Investor Sentiment and Option Prices

Abstract:     
This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. I find that the index option volatility smile is steeper (flatter) and the risk-neutral
skewness of monthly index return is more (less) negative when market sentiment becomes more bearish (bullish). These significant relations are robust and become stronger when there are more
impediments to arbitrage in index options. They can not be explained by rational perfect-market based option-pricing models. Changes in sentiment help explain time variation in the slope of index option smile and risk-neutral skewness beyond factors suggested by the current models.

Number of Pages in PDF File: 34

Keywords: sentiment, pricing kernel, skewness, limits to arbitrage, index option smile

JEL Classification: G12, G13, G14, G10

working papers series