Cross-Sectional Variation of Option-Implied Volatility Skew

Liuren Wu () and Meng Tian ()
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Liuren Wu: Zicklin School of Business, Baruch College, The City University of New York, New York, New York 10010
Meng Tian: Zicklin School of Business, Baruch College, The City University of New York, New York, New York 10010

Management Science, 2024, vol. 70, issue 6, 3566-3580

Abstract: The stock option-implied volatility skew reflects both the structural risk characteristics of the underlying company and the short-term information flow about the stock price movement. This paper builds a semistructural, cross-sectional option pricing model to separate the structural risk contributions from the information flow. The model identifies two structural risk sources that contribute to the cross-sectional variation of the skew: the company’s business cyclicality and its default risk. The model can explain as much as 44% of the cross-sectional variation in implied volatility skew and is particularly informative during and after recessions. The remaining skew variation reflects mainly short-term information flow and can be used to construct stock portfolios with much better investment performance and without hidden structural risk exposures.

Keywords: implied volatility skew; risk-neutral return skewness; cyclicality; default risk; structural risk exposures; information flow; stock return prediction (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:70:y:2024:i:6:p:3566-3580

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