Does Risk-Neutral Skewness Predict the Cross-Section of Equity Option Portfolio Returns?

Abstract:     
We investigate the pricing of risk-neutral skewness in the stock options market by creating skewness assets comprised of two option positions (one long and one short) and a position in the underlying stock. The assets are created such that exposure to changes in the price of the underlying stock (delta), and exposure to changes in implied volatility (vega) are removed, isolating the effect of skewness. We find a strong negative relation between implied risk-neutral skewness and the returns of the skewness assets, consistent with a positive skewness preference. The returns are not explained by well-known market, size, book-to-market, momentum, and short-term reversal factors. Additional volatility, stock, and option market factors also fail to explain the portfolio returns. Neither commonly used metrics of portfolio risk (standard deviation, value- at-risk, and expected shortfall), nor analyses of factor sensitivities provide evidence supporting a risk-based explanation of the portfolio returns.

Number of Pages in PDF File: 72

Keywords: Cross-Section of Expected Returns, Risk-Neutral Skewness

JEL Classification: G10, G11, G12, G13, G14, G17

working papers series