This paper studies how firm’s financial decisions affect the expected return of delta- hedged equity options, both theoretically and empirically. I first derive the expected return of the delta-hedged equity option based on a capital structure model, in which the asset value of a firm is driven by a double exponential jump-diffusion process. Empiri- cally I test the implications of the model using cross-sectional equity option data. After controlling for other firm characteristics such as size and asset volatility, the delta-hedged equity option return decreases with the book leverage of the underlying firm. For the same level of book leverage, the return is more negative in a firm where debt is protected by net-worth covenants. The relation is robust across puts, calls, and moneyness levels and especially evident for out-of-the-money options.
Discussant: Andrei Lalu (UvA)