Cross-sectional Variation of Option Implied Volatility Skew

58 Pages Posted: 1 Dec 2020

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 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

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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