Does the Options Market Underreact to Firms' Left-Tail Risk?

Abstract

We show that firms’ left-tail risk positively predicts future returns of crash insurance. We proxy crash insurance with bear spreads, an option trading strategy that profits when extreme negative returns occur. Crash insurance for high (low) left-tail risk firms earns positive (negative) returns, suggesting that the downside protection it provides is not adequately priced. Our results are mainly explained by two types of underreaction: volatility underreaction in high left-tail risk portfolios and underreaction to the persistence of left-tail risk. Disagreement partially explains our results but a risk-based approach does not.

Keywords: Equity options, Bear spread, Crash risk insurance, Left-tail risk, Behavioral bias, Underreaction

JEL Classification: G12, G13, G14