Cross-sectional Variation of Option Implied Volatility Skew

Abstract

The stock options implied volatility skew reflects both the structural risk characteristics of the underlying company and the short-term information flow about the stock price movement. This paper builds a semi-structural cross-sectional option pricing model to separate the structural risk contributions from the information flow. The model identifies two structural risk sources that contribute to the cross-sectional variation of the skew: the company's business cyclicality and its default risk. The model can explain as much as 44\% of the cross-sectional variation in implied volatility skew and is particularly informative during and after recessions. The remaining skew variation reflects mainly short-term information flow and can be used to construct stock portfolios with much better investment performance and without having hidden structural risk exposures.

Keywords: Implied volatility skew; Risk-neutral return skewness; Cyclicality; Default risk; Structural risk exposures; Information flow; Stock return prediction

JEL Classification: C13; C51; G12; G13