Investor Sentiments, Rational Beliefs and Option Prices
48 Pages Posted: 23 Jul 2014
Date Written: July 22, 2014
This paper explores the impact of investor sentiment on the risk-neutral skewness of S&P 500 index options over the period 1990 to 2011. We decompose the aggregate investor sentiment into an economic fundamentals component that captures investors' rational updating of beliefs and an error in beliefs component that captures investors' expectations not associated with the economic conditions. Our findings reveal a tale of two periods: before June 1997 both the sentiment components affect risk-neutral skewness, while after June 1997 only the fundamentals component is able to explain risk-neutral skewness. Furthermore, the effect of the fundamentals is more pronounced in periods of worsened stock market conditions. By estimating different measures of the slope of the implied volatility smirk, we show that the slope of the calls' implied volatility smirk is driven by investors' expectations about a continuation of recent economic conditions, while the slope of the puts' implied volatility smirk is driven by investors' expectations about a reversal in the economy. Overall, our results highlight the importance of economic fundamentals for explaining the variations in option prices and the pricing kernel.
Keywords: Risk-neutral skewness; Implied volatility smirk; Investor sentiment; Macroeconomy; Index options
JEL Classification: G12, G13
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