Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options

Abstract

This article provides several new insights into the economic sources of skewness. First, we document the differential pricing of individual equity options versus the market index, and relate it to variations in return skewness. Second, we show how risk aversion introduces skewness in the risk-neutral density. Third, we derive laws that decompose individual return skewness into a systematic component and an idiosyncratic component. Empirical analysis of OEX options and 30 stocks demonstrates that individual risk-neutral distributions differ from that of the market index by being far less negatively skewed. This paper explains the presence and evolution of risk-neutral skewness over time and in the cross-section of individual stocks.

JEL Classification: G10, G11, G12