EconPapers    
Economics at your fingertips  
 

Is there information in the volatility skew?

James Doran (), David R. Peterson and Brian C. Tarrant

Journal of Futures Markets, 2007, vol. 27, issue 10, 921-959

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 1984–2006, 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. © 2007 Wiley Periodicals, Inc. Jrl Fut Mark 27:921–959, 2007

Date: 2007
References: Add references at CitEc
Citations: View citations in EconPapers (12) Track citations by RSS feed

Downloads: (external link)
http://hdl.handle.net/

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:wly:jfutmk:v:27:y:2007:i:10:p:921-959

Ordering information: This journal article can be ordered from
http://www.blackwell ... bs.asp?ref=0270-7314

Access Statistics for this article

Journal of Futures Markets is currently edited by Robert I. Webb

More articles in Journal of Futures Markets from John Wiley & Sons, Ltd.
Bibliographic data for series maintained by Wiley Content Delivery ().

 
Page updated 2020-08-06
Handle: RePEc:wly:jfutmk:v:27:y:2007:i:10:p:921-959