Time-Varying Crash Risk Embedded in Index Options: The Role of Stock Market Liquidity

71 Pages Posted: 20 Jun 2016 Last revised: 24 Jul 2018

Peter Christoffersen

University of Toronto - Rotman School of Management; Copenhagen Business School; University of Aarhus - CREATES

Bruno Feunou

Bank of Canada

Yoontae Jeon

Ryerson University - Ted Rogers School of Management

Chayawat Ornthanalai

University of Toronto - Rotman School of Management

Date Written: July 20, 2018

Abstract

We estimate a continuous-time model with dynamic crash probability using the S&P500 index options and high-frequency information. We find that market illiquidity is an important factor in explaining the time-varying stock market crash risk embedded in index options. While market illiquidity and return volatility play complementary roles in explaining the time-varying crash risk, the relative contribution of the volatility factor is weakened once we include market illiquidity as an economic variable. Examining the link between market illiquidity and option-implied crash risk, we find that the availability of arbitrage capital and adverse selection facing liquidity providers are economic driving forces.

Keywords: Market liquidity, Crash risk, Jump intensity, Options, Filtering

JEL Classification: G01, G12

Suggested Citation

Christoffersen, Peter and Feunou, Bruno and Jeon, Yoontae and Ornthanalai, Chayawat, Time-Varying Crash Risk Embedded in Index Options: The Role of Stock Market Liquidity (July 20, 2018). Rotman School of Management Working Paper No. 2797308. Available at SSRN: https://ssrn.com/abstract=2797308 or http://dx.doi.org/10.2139/ssrn.2797308

Peter Christoffersen

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5P 3C4
Canada
416-946-5511 (Phone)

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

Copenhagen Business School

Solbjerg Plads 3
Frederiksberg C, DK - 2000
Denmark

University of Aarhus - CREATES

School of Economics and Management
Building 1322, Bartholins Alle 10
DK-8000 Aarhus C
Denmark

Bruno Feunou

Bank of Canada ( email )

234 Wellington Street
Ottawa, Ontario K1A 0G9
Canada
613-782-8302 (Phone)

HOME PAGE: http://kamkui.net/

Yoontae Jeon

Ryerson University - Ted Rogers School of Management ( email )

350 Victoria Street
Toronto, Ontario M5B 2K3
Canada

Chayawat Ornthanalai (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada

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