X. Chen, B. Du, and X. He: The Risk of Finance Words
This paper proposes a dictionary tailored for volatility analysis in finance research. We investigate the comovement between corporate textual information and option-implied volatility, via robust multinomial inverse regression. The volatility dictionary contains vastly different words from the sentiment dictionary (Loughran and McDonald, 2011) and the colour dictionary (Garcia et al., 2023). The signals distilled from the volatility dictionary explain the cross-sectional variation in implied volatility dynamics, as well as the levels of implied and realized volatility. We find the volatility signals diminish within one day, which is much faster than the assimilation of the expected return signals.
H. Louis, P. Truong, Z. Xu, and Y. Yang: Differences of Opinion and Corporate Investment Efficiency
Differences of opinion among traders are ubiquitous in financial markets. Yet, little is known about their effects on real managerial decisions. We study the impact of differences of opinion on managerial learning from prices and find that differences of opinion are negatively associated with firms’ investment-price sensitivity and subsequent operating performance. This effect is driven by non-financially constrained firms, firms whose managers possess less private information, and high-growth firms, consistent with reduced managerial learning from prices. Overall, the evidence suggests that differences of opinion reduce the precision of price and its ability to guide real investment decisions as an information signal.
J. Ma and Y. Zhang: Option Price Asymmetry, Speculation and Stock Short-Sale Cost
We introduce the variable implied variance asymmetry (IVA), defined as the difference between put and call option prices, and demonstrate that it is negatively correlated with future cross-sectional delta-hedged call option returns and positively correlated with future delta-hedged put option returns. The negative relationship between IVA and call option returns is driven by speculators, while the positive relationship between IVA and put option returns is linked to stock short-sellers. Furthermore, we find that stocks and put options with low IVA and high short-sale costs exhibit significantly negative excess returns, suggesting that the traders driving the overpricing of put options are more informed participants in the stock market. In contrast, high prices for call options with high IVA are driven by retail investors, who are attracted to speculative characteristics but lack information about future stock returns.
L. Mu: Ross Recovery Theorem, Risk-Free Rates, and Risk-Neutral Returns
This paper investigates the information embedded in state prices, specifically risk-free rates and risk-neutral returns, and highlights the limitations of the Ross recovery theorem. We theoretically demonstrate the application of Ross recovery under flat term structures of risk-free rates and risk-neutral returns. We propose novel empirical approaches incorporating implicit conditions related to risk-free rates and risk-neutral returns. Using S&P 500 options data, we find that the Ross recovery theorem not only fails to align with market realities but also offers limited additional information compared to risk-neutral probabilities.
G. Bakshi, J. Crosby, X. Gao, and J. W. Hansen: A Theory of Small Maturity Effects and Data Realities of 7DTE Treasury Options across Tenors
This study introduces data on weekly expiring (7DTE) Treasury options and presents two observations. First, the 7DTE risk-neutral distributions of the 30-year bond futures are right-shifted compared to their 10-year counterparts. Second, the return skewness for both tenors changes direction, with the 30 (10)-year exhibiting positive (negative) skewness on average. We propose a model with two Poisson processes and stochastic intensity rates as an explanation. The model accounts for correlated price jump distributions, differing in expected jump sizes between the tenors, for both down and up movements. The estimated 7DTE model supports the theoretical implications of the two empirical observations.
R. Baule and L. Sperling: Transition Risk Premiums in Option Prices
The economy is in a transition process to a low-carbon state, inducing an additional source of risk for stocks, the transition risk. Using a measure of transition risk at individual firm level, the carbon beta developed by Goergen et al. (2020), we analyze various option measures to examine the relationship between a firm’s transition risk and option hedging costs. In contrast to the previous literature, we find evidence that only the absolute value of a firm’s exposure to the transition process, and not its sign, is relevant for the expensiveness of options. In particular, options on firms with a high absolute value of the carbon beta are charged with a higher volatility risk premium, whereas anticipated downside tail risks are larger for green firms. The pricing of transition-related volatility risk is increasing over time and appears to be a fairly new phenomenon.
A. Tseng, J. D. Schloetzer, X. Li, and H. Wang: The Role of Private Meetings with Management in Reducing Investor Uncertainty Around Subsequent Earnings Announcements
Scholars and regulators posit that investors leverage previously obtained private information when responding to firms’ subsequent public disclosures. We empirically test this hypothesis by examining the occurrence of private meetings with management preceding earnings announcements. Specifically, we focus on firms that issue stand-alone management guidance alongside private meetings, compared to a matched sample of firms that also issue stand-alone guidance but do not hold such meetings. Our findings indicate an incremental 10 percent reduction in investor uncertainty surrounding the subsequent earnings announcements of firms with private meetings relative to those without. This reduction is more pronounced for firms with more soft information, suggesting that investors derive valuable insights from these meetings. We conclude that the soft information gathered during private meetings aids investors in interpreting subsequent earnings announcements with implications for resolving investor uncertainty.
S. Balasubramaniam and A. David: Hoarding, Stockouts, and Commodity Futures Prices During the Pandemic
During the pandemic, processed foods and other essential products frequently ran out at retail stores while disruptions in production and the supply chain lead to weakness in their underlying spot commodities markets causing negatively related consumer and producer price inflation. In addition, the correlation between retail stockouts of processed goods and the futures basis of the raw material input commodities was positive for most of 2020, while the theory of storage predicts a negative relationship. To understand these findings, we provide a theoretical model in which severe labor shortages lead to contango in the futures market for raw materials, which in turn, influences consumers’ hoarding decisions. Our model exhibits an efficient ‘no hoarding’ equilibrium as well as an inefficient ‘hoarding equilibrium’, depending on the commodity futures’ slope. The hoarding equilibrium can arise in a period of dropping wholesale prices, and exhibits rising consumer prices.
V. Patel, D. Michayluk, and A. Dhawan: Unveiling synergy gains in divestitures using options market information
We use stock and options information to decompose and provide a practical measure of the market’s beliefs about the different sources of value creation from divestitures. We find that divestitures generate economically significant synergy gains which exceed $1,000 million for acquirers and sellers. These gains are partially offset by negative new information that the divestiture announcement reveals about their stand-alone value. In contrast to prior findings which indicate that divestitures create little to no value, we find that divestitures create significant value, and they can serve as an important strategic tool which can create more value than mergers and acquisitions.
D. Huang, Y. Liang: The Asymmetric Effects of Monetary Policy Shocks: Evidence from Credit Default Swap Markets
The paper investigates the complex interplay between monetary policy, firm financial health, and credit market dynamics. Using credit default swap (CDS) data, we demonstrate that financial constraints modulate the magnitude of CDS spread responses and fundamentally shape the temporal pattern of these reactions and associated trading activities. Our findings reveal a stark dichotomy: financially constrained firms exhibit pronounced, immediate CDS spread expansions following monetary policy surprises (MPSs), while unconstrained entities display more subdued yet persistent reactions over extended event windows. More importantly, we unveil the underlying mechanism by uncovering a nuanced dynamic in trading volumes, where constrained firms experience a significant, short-term decrease in CDS market depth post-policy tightening, contrasting sharply with the resilient trading volumes of unconstrained firms. Our discoveries imply that monetary policy may have unintended distributional effects, potentially exacerbating financial fragilities for constrained firms while having more gradual, persistent impacts on unconstrained entities.
P. Pederzoli, H. Doshi and S. A. Sert: Risky Intraday Order Flow and Equity Option Liquidity
We examine the effect of intraday order flow volatility on option market illiquidity. We document a robust positive relationship between order flow volatility and illiquidity, both in time series and the cross-section of short-maturity index and individual equity options. The impact of order flow volatility varies significantly by option maturity, decreasing as maturity increases, underscoring the higher sensitivity of liquidity in ultra-short maturity options. We leverage multi-exchange trading of individual stock options to isolate the direct trade absorption costs from indirect costs. This analysis reveals that, while both cost components are significant, indirect costs dominate, with exchanges adjusting based on aggregate order flow risk across venues. Overall, our results contribute to the understanding of how effectively liquidity providers provide liquidity in this relatively novel market of short-maturity options.
S. Bhojraj, M. Dantas, G. Gao, J. Piao and F. B. G. Silva: The Nature of Stock Price Crash Risk: Hoarding of Bad News or Non-Agency Uncertainty?
We reassess the longstanding bad news hoarding hypothesis that underlies the vast literature on the effects of financial reporting on firms’ stock price crash risk. We propose a series of tests to help distinguish between crash risks due to bad news hoarding visa -vis the underlying risk exposures of firms (non-agency uncertainty hypothesis). The three pillars of these tests are (i) to analyze both tails of the return distribution, (ii) to differentiate between isolated and coincident crashes and booms, and (iii) to account for investors’ expectations. Opacity is the only financial reporting quality proxy that survives the additional tests and is consistent with bad news hoarding. Our findings collectively provide a roadmap to better understand the underlying channels connecting financial reporting and crash risks.
L. Zhou, R. Wang, W. K. Härdle, X. Zuo and H. W. Teng: Pricing kernels are often non-monotone…
Nonparametric estimation of the pricing kernel has led to a “puzzle”, that challenged finance principles. The apparent non monotonicity of the empirical pricing kernel has been addressed as improper use of past and future observations. A new CDI spline based smoothing technique-reflecting the forward looking information sets-puts the estimated pricing kernel into a seemingly theory compatible shape. Our findings, though, show equivalence between the two techniques. We discover that CDI cannot be fully consistent since it relies on averaging in an almost constant stochastic dynamics world. Empirical insights rather point to economic phenomena and not to technical flaws.
J. Gao and J. Pan: Option-Implied Crash Index
This paper offers a model-based crash index (CIX) by exploring the pricing difference between out-of-the-money put options and at-the-money options via a jump-diffusion model (SVJ) with stochastic volatility and jump risk. Analogous to the VIX index as the option-implied volatility, our CIX index is the option-implied mean crash size of the SVJ model. Empirically, the CIX index is closely related to the non-parametric option-implied skewness, indicating the importance of the crash component. Moreover, we document a significant upward trend in the CIX index in recent years, which coincides with the increasing trend of investors’ crash narratives derived from news coverage.
D. J. Cumming, S. Ji and C. Sala: Option Market Manipulation
We investigate the behavior of options markets in response to potential stock market manipulations, with a specific focus on cross-product manipulation. Unlike existing literature, we rely on a dataset of manipulated stock prices, thereby avoiding the joint hypothesis problem. Key findings reveal a discernible increase in trading volume preceding manipulation events, with a preference for short-term, out-of-the-money options. The study also highlights inefficiencies in the options market during manipulation periods and examines factors influencing traders’ strategies. Results are not explained by volatility, firm-specific information, and do not indicate day-of-week effects.
P. Pederzoli, K. Jacobs and A. T. Mai: Why Does Volatility Demand Fall During Market Turmoil? A Market Maker Perspective
End users typically hold net long VIX call options to hedge against market downturns but paradoxically reduce these positions during such times. We explain this puzzle by estimating the latent demand curves for market makers and end users in a zero net supply market, using the time series of their net positions and equilibrium prices. During high-risk periods, both demand curves shift right, with market maker demand reacting more strongly, especially for short-maturity options. This results in reduced net long positions of end users, higher volatility returns, and wider bid-ask spreads. Unconditionally, market maker demand increases when inventory constraints and expected volatility returns are high, highlighting their role in shaping market equilibrium as they manage inventory and profits while maintaining continuous market liquidity.
K. Buzard, N. Canen and S. M. Saiegh: Mitigating Policy Uncertainty: What Financial Markets Reveal About Firm-Level Lobbying
Elections can lead to significant changes in policy and, thus, are a significant source of policy uncertainty. Firms can respond to such uncertainty by lobbying, but it is hard to quantify whether they do so and, if so, how much lobbying benefits them. We construct a new dataset and firm-level measure of exposure to policy uncertainty using investors’ expectations of variability in stock returns in the aftermath of the 2020 US presidential election. We show that lobbying reduces policy uncertainty, and that this result holds even after controlling for selection into lobbying and for sectoral heterogeneity. We then develop and quantify a model of heterogeneous firms with endogenous lobbying. We find that affecting policy through lobbying is costly and the returns from it are highly skewed and rapidly diminishing. Thus, while lobbying expenditures reduce the impact of policy risk, few firms anticipate sufficient gains to invest in it.
A. Ober: Unhedgeable Risks and their Relation to Pricing Kernels Implicit in Options
This paper studies pricing kernels and their relation to jump and variance premia in an intermediary-based index option pricing model. After solving the model using neural nets, I show that when market makers net sell options, the pricing kernel is U-shaped in underlying returns. This result is primarily driven by the market maker’s inability to perfectly hedge large movements, or jumps, in underlying returns. The model thus provides a joint explanation for historically observed U-shaped kernels, large jump premia for upward and downward jumps in the market, and expensive out-of-the-money calls and puts which pay off under large upward and downward jumps, respectively. Changes in the market maker’s financial standing generate changes in the pricing of jump risk, for both upward and downward jumps, that are consistent with the model. Changes in end user demand since the financial crisis are consistent with a disappearance of the U shape in the pricing kernel and a decrease in option prices, as predicted by the model.
E. Barthe: Do Retail Structured Products Distort Equity Volatilities?
I investigate how the hedging activity of structured products affects equity volatilities, contributing to the structured products literature and examining the influence of option supply/demand on volatility. When a new retail structured product is issued (autocallable, barrier reverse convertible, reverse convertible etc.), it creates a net supply of gamma. The rehedging activity of banks compresses the realised volatility of those underlyings. The volumes are large enough to have a significant impact on the volatility surfaces of the most popular underlyings. That phenomenon gives birth to profitable trading strategies in dispersion format.
G. Bakshi, J. Crosby, X. Gao, J. Xue and W. Zhou: The Options-Inferred Equity Premium and the Slippery Slope of The Negative Correlation Condition
The negative correlation condition (NCC) of Martin (2017) is that cov P t (M T R T , R T) ≤ 0 for all M T , where M T is the SDF and R T is the gross market return. He employs this assumption to derive a lower bound of the equity premium. This paper exploits theoretical and empirical constructions to refute the hypothesis of the NCC. Using options on the S&P 500 index and STOXX 50 equity index, our tests favor rejection. Our empirical counterexamples of M T contradict the universality of the NCC, exhibit variance-dependence and incorporate an increasing region to the return upside.
Z. Da, R. Goyenko, C. Zhang: Intraday Option Return: A Tale of Two Momentum
Intraday returns on option straddles display the same persistent seasonality pattern as its underlying stock, even though straddles are delta-neutral. Specifically, straddle return in a given half-hour interval today positively predicts the return in the same intraday interval tomorrow. Such a continuation pattern is most prominent at the market open and close, which we label as morning and afternoon momentum, respectively. We find that morning momentum reflects investors’ underreaction to volatility shocks, while afternoon momentum is driven by persistent inventory management by option market makers.
X. Li: The Cross-Section of Dividend Discount Rates
I study how short-term dividends are priced in the cross section of US stocks. I estimate the prices of synthetic short-term dividend assets from equity option prices, which are adjusted for their early exercise premia. I find that cross-sectional variations in short-term dividend prices are substantial and driven predominantly by cross-sectional differences in short-term discount rates. Dividend assets with lower price-dividend ratios deliver higher average returns than those with higher price-dividend ratios. Firms deriving more value from short-term dividends tend to invest and hire less. I evaluate the model-implied cross-section of short-term dividend prices and returns in three leading asset pricing models.
D. Ardia and T. J. Boye: Climate Change Concerns and Option-Implied Stock Returns ⋆
We empirically test if the findings in Ardia et al. (2023)-that low-greenhouse-gas-emitting firms outperform high-greenhouse-gas-emitting firms when climate change concerns increase unexpectedly-extend to option-implied stock returns using daily options data of U.S. companies from January 2010 to June 2018. We find option-implied returns exhibit a weaker relationship with unexpected increases in climate change concerns than realized returns, and this relationship is only significant for climate-change themes related to the transition risk.
A. Soebhag, G. Baltussen and Z. Da: End-of-Day Reversal
Individual stocks experience sharp intraday return reversals in the cross-section during the last 30 minutes of the trading day. This “end-of-day reversal” pattern is economically and statistically highly significant, is distinct from market intraday momentum, and primarily comes from positive price pressure on intraday losers. The effect cannot be explained by liquidity or gamma hedging effects. Instead, two novel channels related to the attention-induced retail purchases and risk management by short-sellers at the end of the day are driving the effect.
G. Lee, D. Ryu and L. Yang: Domain stabilization for model-free option implied moment estimation
We propose a new method, domain stabilization (DStab), to enhance the return predictive and forecasting ability of model-free option-implied moment estimators. Analyzing S&P 500 options data from January 2015 to December 2021, we show that DStab improves moment estimation consistency by stabilizing the integration domain, leading to better predictive and forecasting performance. When the options data characteristics are appropriately considered, DStab enhances both in-sample predictive and out-of-sample forecasting abilities of implied moments. DStab’s out-of-sample forecasting ability surpasses other treatment methods.
A. Bernales, L. Reus, L. Chen, T. Verousis and J. Azocar: Option Listings, Stock Price Informativeness and Investment Decisions
We show that a common financial innovation-stock option listings-enhances the ability of firm managers to extract valuable information from market prices, which they then use in their investment decisions. We structure our empirical analysis around a stylized learning model, providing a motivating framework. We show that the investment-to-price sensitivity increases significantly in the years after the stock option listing date. Moreover, the increase in investment-toprice sensitivity is more pronounced when the new stock options are successfully adopted by investors, as this leads to greater informational improvements. Our results suggest strong links between financial innovations and real economic decisions.
G. DeSimone and O. Shih: Reducing Risk through Multifactors: Implied Variance Asymmetry and Implied Beta
OptionMetrics’ latest study challenges conventional risk assessment using metrics like implied variance asymmetry (IVA), calculated as the measure of downside variance relative to upside variance, and option-implied beta strategies. By combining low beta with high IVA, we yield a superior portfolio with 12% annualized return, 0.85 Sharpe Ratio, and 1.23 Sortino Ratio. Contrary to expectations, the relationship between IVA and returns suggests complexities beyond simple risk factors, with high IVA portfolios showing lower downside variance and better risk-adjusted returns relative to the benchmark.
G. DeSimone and A. Rotach: The Implied Advantage: Empowering Beta-Neutrality with Options-Based Metrics
In this research, we present evidence showcasing the superior effectiveness of implied betas in achieving beta neutrality for leveraged long/short factor portfolios compared to historical beta estimates. We find that nearly all portfolios using implied beta for leverage calculation are more successful in approximating the target beta of zero.
G. DeSimone, A. Gupta, A. Rotach & O. Shih: The Implied Bet Against Beta (IBAB) Factor: A New Frontier for Low-Volatility Investing
In this research, we introduce a new factor, IBAB, which utilizes implied betas to construct a long-short portfolio of leveraged low-beta and short high-beta securities. Our results show that in the universe of S&P 500 constituents, IBAB outperforms the traditional BAB factor, with an annualized return of 5.3% compared to BAB’s -3.0%. Moreover, IBAB delivers a positive FF5 alpha of 2.5% while BAB exhibits a negative alpha of -6.0%. We further investigate the economic drivers behind the performance difference between IBAB and BAB and find that the implied correlation component of IBAB is the main driver of its superior performance.
G. DeSimone: Demand for Option Order Delta
OptionMetrics’ latest research paper, Demand for Option Order Delta (DOOD), proposes a new options-based metric to estimate demand imbalance for delta by end-users of options. Read the full white paper below to learn more.
G. DeSimone: Emergency Rate Cuts and Beware of the Bull Steepener
On March 3, 2020, the Federal Reserve announced its first emergency rate cut since the Financial Crisis in order to combat mounting Coronavirus fears. This rate trimming of 50 basis points from 1.75% was intended to calm markets and reduce business uncertainty. The rare nature of such actions provides valuable information regarding the current economic backdrop.
G. DeSimone: Assessing Option Demand from Signed Volume Order Flow
Supply and demand in option markets matter. A critical assumption of popular pricing models, such as Black-Scholes is that investors are subject to a no-arbitrage constraint, which implies a perfect elasticity of supply. In reality, a market maker will not provide endless options contracts without charging higher prices. This demand theory of option pricing is a crucial piece in understanding the behavior of implied volatility surfaces.
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Assessing Option Demand from Signed Volume Order Flow
G. DeSimone: Min Vol: More than a Safety Trade
Minimum volatility strategies are having a scorching run in 2019. This year min volatility funds are boasting outperformance above the benchmark in a largely bull market, with IShares Min Vol ETF (USMV) gaining 22% against S&P 500’s 19%. These figures may come across as surprising; min vol is typically pitched as safety trade with better downside protection than the market, but less upside potential. Is minimum volatility purely a defensive portfolio solution?
G. DeSimone: Amplified Momentum
This article takes a deeper look at the drivers of the momentum factor. A traditional momentum strategy involves buying winners and selling losers based on the past 12 months returns. This strategy can be amplified by selecting stocks within the Winner-minus-Loser portfolio that have high implied idiosyncratic volatility (IVOL), extracted from option prices. The short portfolio of high IVOL loser stocks generates significant underperformance, due these stocks being overpriced by investors for their lottery-like payoffs.
G. DeSimone, P. A. Laux: The Timing of Variance Risk Premia Around Macroeconomic News Events
The majority of the variance risk premia is concentrated around the time of macroeconomic news announcements. Risk premia embodied in variance futures are negative around such events, consistent with theory. Risk premia in index option straddle positions are also negative around announcements, except that they are positive around Fed Open Market Committee (FOMC) meetings. Upon decomposing the straddle returns, we find that they primarily represent compensation for jump risk. On the other hand, the positive returns on FOMC meetings are due to extraordinary actions by the board to calm volatility.
D. Hait: VIX — Fear of What?
The VIX, while promoted as an indicator of future market volatility, has more to do with present and past market returns than future volatility. Most (98.8%) of the daily variation in the VIX can be explained by current SPX returns and lagged VIX values. Unexplained changes in the VIX are more likely due to contemporaneous market reactions rather than fear of future events. Despite its lack of predictive ability, the VIX could be useful as a hedge against bidirectional jump risk.