Feedback, Flow-induced Fire Sales, and Option Returns

59 Pages Posted: 2 Aug 2021 Last revised: 4 Sep 2021

See all articles by Han Xiao

Han Xiao

Pennsylvania State University

Date Written: July 9, 2021

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

Suggested Citation

Xiao, Han, Feedback, Flow-induced Fire Sales, and Option Returns (July 9, 2021). Available at SSRN: https://ssrn.com/abstract=3881317 or http://dx.doi.org/10.2139/ssrn.3881317

Han Xiao (Contact Author)

Pennsylvania State University ( email )

University Park, PA 16802
United States

HOME PAGE: http://han-xiao.weebly.com

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