The Supply and Demand of S&P 500 Put Options

Abstract

We document that the skew of S&P500 index puts is non-decreasing in the disaster index and risk-neutral variance, contrary to the implications of no-arbitrage models. Our model resolves the puzzle by recognizing that, as the disaster risk increases, customers demand more puts as insurance while market makers become more credit constrained in writing puts. The skew steepens because the credit constraint is more sensitive to out-of-the-money puts. Consistent with the data, the model also predicts that the skew is increasing in the broker-dealers' liability-to-asset ratio; and the net buy of puts is decreasing in the disaster index, variance, put price, and liability-to-asset ratio.

Keywords: S&P 500 options; option supply; option demand; market maker credit constraints; Value-at-Risk; implied volatility skew; net buy; disaster risk; variance risk

JEL Classification: G11, G12, G23