The importance of the loss function in option valuation

Abstract

After the financialization of commodity futures markets in 2004–2005 oil volatility has become a strong predictor of returns and volatility of the overall stock market. Furthermore, stocks’ exposure to oil volatility risk now drives the cross-section of expected returns. The difference in average return between the quintile of stocks with low exposure versus high exposure to oil volatility is significant at 0.66% per month, and oil volatility risk carries a significant risk premium of 0.60% per month. We also find that increases in oil price uncertainty predict tightening funding constraints of financial intermediaries suggesting a link between oil volatility risk and the stock market.