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H. Park, B. Kim, H. Shim, “A Smiling Bear in the Equity Options Market and the Cross-Section of Stock Returns,” (working paper series)

H. Park, B. Kim, H. Shim, “A Smiling Bear in the Equity Options Market and the Cross-Section of Stock Returns,” (working paper series)

Abstract: We propose a measure for the convexity of an option-implied volatility curve, IV convexity, as a forward-looking measure of excess tail-risk contribution to the perceived variance of underlying equity returns. Using equity options data for individual U.S.-listed stocks during 2000-2013, we find that the average return differential between the lowest and highest IV convexity quintile portfolios exceeds 1% per month, which is both economically and statistically significant on a risk-adjusted basis. Our empirical findings indicate that informed options traders anticipating heavier tail risk proactively induce leptokurtic implied distributions of underlying stock returns before equity investors express their tail-risk aversion.