Market Crash Risk and Implied Volatility Skewness: Evidence and Implications for Insurer Investments

27 Pages Posted: 22 Apr 2006

See all articles by James Doran

James Doran

University of New South Wales

James M. Carson

University of Georgia

David R. Peterson

Florida State University - Department of Finance

Date Written: April 21, 2006

Abstract

Insurers in the U.S. hold over $5 trillion in assets, with approximately $1 trillion of these assets held in equities. While insurers manage underwriting risk with reinsurance, insurers increasingly manage asset risk with options, futures, and other derivatives. We demonstrate, using all options on the S&P 100 from 1996-2002, that 1) the shape of the implied volatility skew has statistically and economically significant forecast power for assessing the degree of market crash risk, 2) implied volatility skew coefficients are significant and consistent with market crash hypotheses, 3) the cost of hedging with put options (crash insurance) varies directly with the probability of market crash, and 4) hedging is least (most) likely to be cost-effective during bull (bear) markets and when the probability of a market crash is below (above) specified threshold levels. Findings are consistent with investor aversion to large losses, and the evidence suggests that a dynamic hedging program dominates continuous hedging for maintaining insurer financial strength.

Keywords: Market crash risk, Implied volatility skew, Investments, Dynamic Hedging, Insurer financial strength

JEL Classification: G11, G22, G31

Suggested Citation

Doran, James and Carson, James M. and Peterson, David R., Market Crash Risk and Implied Volatility Skewness: Evidence and Implications for Insurer Investments (April 21, 2006). Available at SSRN: https://ssrn.com/abstract=897401 or http://dx.doi.org/10.2139/ssrn.897401

James Doran

University of New South Wales ( email )

College Rd
Sydney, NSW 2052
Australia

James M. Carson (Contact Author)

University of Georgia ( email )

Athens, GA 30602-6254
United States

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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