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

72 Pages Posted: 30 Jan 2012 Last revised: 25 Apr 2012

Turan G. Bali

Georgetown University - Robert Emmett McDonough School of Business

Scott Murray

Georgia State University

Multiple version iconThere are 2 versions of this paper

Date Written: April 20, 2012

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.

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

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

Suggested Citation

Bali, Turan G. and Murray, Scott, Does Risk-Neutral Skewness Predict the Cross-Section of Equity Option Portfolio Returns? (April 20, 2012). Available at SSRN: https://ssrn.com/abstract=1993321 or http://dx.doi.org/10.2139/ssrn.1993321

Turan G. Bali (Contact Author)

Georgetown University - Robert Emmett McDonough School of Business ( email )

3700 O Street, NW
Washington, DC 20057
United States
(202) 687-5388 (Phone)
(202) 687-4031 (Fax)

HOME PAGE: http://msbonline.georgetown.edu/faculty-research/msf-faculty/turan-bali

Scott Murray

Georgia State University ( email )

35 Broad Street
Atlanta, GA 30303-3083
United States

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