Feedback, Flow-induced Fire Sales, and Option Returns
59 Pages Posted: 2 Aug 2021 Last revised: 4 Sep 2021
Date Written: July 9, 2021
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
Suggested Citation: Suggested Citation