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

51 Pages Posted: 10 Oct 2000

See all articles by Nikunj Kapadia

Nikunj Kapadia

University of Massachusetts Amherst - Department of Finance

Gurdip Bakshi

Fox School of Business

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business

Date Written: June 26, 2000

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

Suggested Citation

Kapadia, Nikunj and Bakshi, Gurdip S. and Madan, Dilip B., Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options (June 26, 2000). EFA 0162. Available at SSRN: https://ssrn.com/abstract=239528 or http://dx.doi.org/10.2139/ssrn.239528

Nikunj Kapadia

University of Massachusetts Amherst - Department of Finance ( email )

Amherst, MA 01003
United States
413-545-5643 (Phone)
413-545-5600 (Fax)

HOME PAGE: http://www-unix.oit.umass.edu/~nkapadia/

Gurdip S. Bakshi (Contact Author)

Fox School of Business ( email )

Department of Finance
Philadelphia, PA 19022
United States
215-204-6117 (Phone)
tuk40718@temple.edu (Fax)

HOME PAGE: http://https://sites.google.com/view/gurdipbakshi1

Dilip B. Madan

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
301-405-2127 (Phone)
301-314-9157 (Fax)

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