Feedback, Flow-induced Fire Sales, and Option Returns

Abstract

We identify a feedback loop between fire sales and equity option returns. The demand effect of fire sales induced by mutual fund extreme outflows decreases delta-hedged put option returns by 4-10% per year and increases the expensiveness by 2.5%. We address endogenous concerns using instrumental variable and difference-in-differences designs. The demand effect is more substantial under equity illiquidities than volatility, distress, sustainability risks, or short-sale constraints. Option returns also have anticipation effects on predicting fire sales, where information leakage in derivatives markets exacerbates extreme outflows.

Keywords: Fire sale, mutual funds, option, demand, feedback loop

JEL Classification: G13, G14, G23