Noise Trading and the Cross-Section of Index Option Prices

Fabian Irek (), Thorsten Lehnert and Nicolas Martelin

LSF Research Working Paper Series from Luxembourg School of Finance, University of Luxembourg

Abstract: Traditional financial theory predicts that noise trader sentiment plays no role for the cross-sectional pattern in stock returns and in the cross-section of option prices. However, empirical research is challenging that view and finds evidence that investor sentiment can be predicted to affect the cross-section of stock returns. In the options literature, research suggests that market sentiment correlates contemporaneously with implied volatilities and the risk-neutral skewness, but the causality is unclear. In recent years, there has been plenty of evidence supporting the notion that mutual fund investors can be classified as noise traders and equity fund flows capture noise trader sentiment. In this paper, using daily aggregated US equity fund flows as a measure of noise trader sentiment, we empirically investigate if the cross-section of index option prices is conditional on our beginning-of-period proxy of noise trading. Overall, our results strongly suggest that noise from the stock market is transmitted into the index option market. We find that when noise traders are bearish (bullish) on a particular day, resulting in flows out of (in) US equity funds, implied volatilities of S&P500 index options tend to significantly increase (decrease) on the following day. Furthermore, our findings suggest that the observed increase (decrease) of risk-neutral skewness of index options is caused by bearish (bullish) noise traders active in the equity market. In line with intuition and other evidence, the effects are more pronounced for out-ofthe- money options and short-term options.

Keywords: Option Prices; Noise Trading; Implied Volatility; Risk-neutral Skewness; Fund Flows. (search for similar items in EconPapers)
JEL-codes: C15 G12 (search for similar items in EconPapers)
Date: 2012
New Economics Papers: this item is included in nep-mst
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Persistent link: https://EconPapers.repec.org/RePEc:crf:wpaper:12-1

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