Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options

Abstract

How do risk-neutral return skews evolve over time and in the cross-section of individual stocks? We document the differential pricing of individual equity options versus the market index, and relate it to variations in the skew. The change-of-measure induced by marginal-utility tilting of the physical density can introduce skews in the risk-neutral return density. We derive the skew laws that decompose individual return skewness into a systematic skewness component and an idiosyncratic skewness component. Our empirical analysis of OEX options and 30 of its individual components demonstrates that individual risk-neutral distributions differ from that of the market index by being far less negatively skewed, and substantially more volatile.

Keywords: risk neutral skews, option pricing, individual stock options

JEL Classification: G10, G11