Is There Information in the Volatility Skew?

Journal of Futures Markets, Vol. 27, pp.921-960, October 2007

43 Pages Posted: 17 Jan 2006 Last revised: 5 Jun 2009

See all articles by James Doran

James Doran

University of New South Wales

Brian C. Tarrant

Central Michigan University

David R. Peterson

Florida State University - Department of Finance

Date Written: 2007

Abstract

Since the 1987 crash, option prices have exhibited a strong negative skew, implying higher implied volatility for out-of-the-money puts than at- and in-the-money puts. This has resulted in incorporating multiple jumps and stochastic volatility within the data generating process to improve the Black-Scholes model in an attempt to capture negative skewness and a highly leptokurtic distribution. The general conclusion is that there is a large jump premium in the short-term, which best explains the significant negative skew for short maturity options. Alternative explanations for the negative skew are related to market liquidity driven by demand shocks and supply shortages. Regardless of the explanation for the negative skew, we assess the information content in the shape of the skew to infer if the option market can accurately forecast stock market crashes and/or spikes upward. We demonstrate, using all options on the S&P 100 from 1996-2002, that the shape of the skew can reveal with significant probability when the market will "crash" or "spike". However, we find the magnitude of the spike prediction is not economically significant. Our findings are strongest for the short-term out-of-the money puts, consistent with the notion of investors' aversion to large negative movements. We also find that the power of the "crash/spike prediction" decreases with an increase in the time to option maturity.

Keywords: Volatility Skew, Option Pricing, S&P 100, Market Crashes, OEX

JEL Classification: G11, G12, G13

Suggested Citation

Doran, James and Tarrant, Brian C. and Peterson, David R., Is There Information in the Volatility Skew? (2007). Journal of Futures Markets, Vol. 27, pp.921-960, October 2007, Available at SSRN: https://ssrn.com/abstract=874991

James Doran (Contact Author)

University of New South Wales ( email )

College Rd
Sydney, NSW 2052
Australia

Brian C. Tarrant

Central Michigan University ( email )

Mount Pleasant, MI 48859
United States
989.774.2034 (Phone)

David R. Peterson

Florida State University - Department of Finance ( email )

Tallahassee, FL 32306-1042
United States
850-644-8200 (Phone)
850-644-4225 (Fax)

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