Cross-sectional Variation of Option Implied Volatility Skew

Abstract

The slope of the option implied volatility plot against the strike reflects the risk-neutral skewness of the underlying security's conditional return distribution. We identify two principal risk sources that contribute to the cross-sectional variation of individual stock options' implied volatility skew: the market risk exposure of the stock's return and the company's default risk. Once controlled for these two risk exposures and the implied volatility level, the remaining idiosyncratic variation of the implied volatility skew reflects more of investor expectation and sentiment on the stock's future price movement and can be used to predict future stock returns with more accuracy.

Keywords: Implied volatility skew; Market risk; Credit risk; Market sentiment; Return prediction

JEL Classification: C13; C51; G12; G13