Time-Varying Crash Risk Embedded in Index Options: The Role of Stock Market Liquidity
71 Pages Posted: 20 Jun 2016 Last revised: 2 Dec 2020
Date Written: July 20, 2018
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: Suggested Citation