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Investor Sentiments, Rational Beliefs and Option Prices

48 Pages Posted: 23 Jul 2014  

Panayiotis C. Andreou

Cyprus University of Technology

Anastasios Kagkadis

Lancaster University - Department of Accounting and Finance

Dennis Philip

Durham University Business School

Date Written: July 22, 2014

Abstract

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

Suggested Citation

Andreou, Panayiotis C. and Kagkadis, Anastasios and Philip, Dennis, Investor Sentiments, Rational Beliefs and Option Prices (July 22, 2014). Available at SSRN: https://ssrn.com/abstract=2469772 or http://dx.doi.org/10.2139/ssrn.2469772

Panayiotis Andreou

Cyprus University of Technology ( email )

School Of Management and Economics
P.O. Box 50329
Lemesos, 3036
Cyprus

HOME PAGE: http://www.pandreou.com

Anastasios Kagkadis (Contact Author)

Lancaster University - Department of Accounting and Finance ( email )

The Management School
Lancaster LA1 4YX
United Kingdom

Dennis Philip

Durham University Business School ( email )

Department of Economics and Finance
Mill Hill Lane
Durham, DH1 3LB
United Kingdom

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