Cross-sectional Variation of Option Implied Volatility Skew

43 Pages Posted: 1 Dec 2020 Last revised: 25 Jul 2022

See all articles by Meng Tian

Meng Tian

City University of New York, CUNY Baruch College - Zicklin School of Business

Liuren Wu

City University of New York, CUNY Baruch College - Zicklin School of Business

Date Written: October 7, 2020

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

Suggested Citation

Tian, Meng and Wu, Liuren, Cross-sectional Variation of Option Implied Volatility Skew (October 7, 2020). Available at SSRN: https://ssrn.com/abstract=3707006 or http://dx.doi.org/10.2139/ssrn.3707006

Meng Tian

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
New York, NY 10010
United States

Liuren Wu (Contact Author)

City University of New York, CUNY Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-247
New York, NY 10010
United States
646-312-3509 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/lwu/

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