This paper examines specification issues and estimates diffusive and jump risk premia using the cross-section of S&P futures option prices from 1987 to 2003. We first test for the presence of jumps in volatility by analyzing the higher moment behavior of option implied variance. We find strong evidence supporting their presence. Based on the cross-sectional fit of option prices, we find strong evidence for jumps in prices and modest evidence for jumps in volatility. Regarding factor risk premia, we are not able to identify a statistically significant diffusive volatility risk premium, but are able to identify statistically significant, though modest, risk premia for jumps in prices and volatility. These jump risk premia are economically meaningful, as they contribute a significant component to the equity risk premium and can help explain observed put returns.
Journal of Finance. Forthcoming.