Risk-Neutral Skewness: Return Predictability and Its Sources

Abstract

Using data on individual stock options, we show that the currently observed option-implied ex ante skewness is positively related to future stock returns. This contrasts with the existing evidence that uses historical stock or option data to estimate skewness and finds a negative skewness-return relation. We proxy for the ex ante skewness by using the model-free implied skewness (MFIS) and show that high MFIS stocks outperform low MFIS stocks by 45 basis points per month after correcting for systematic exposure. We find that the positive MFIS-return relation stems from the ability of the current MFIS to identify the deviation of a firm’s value from its fundamental value, and the most overvalued stocks have the most negative ex ante skewness. We further find that the speed of the value correction process depends on the arbitrage risk faced by arbitrageurs trying to exploit the observed inefficiencies. Our results have implications for the segmentation of equity and options markets as well as for limits of arbitrage in equity markets.

Keywords: implied skewness, risk-neutral skewness, options, firm misvaluation, return predictability, beliefs

JEL Classification: G11, G14