Last Updated on 10 February, 2024 by Rejaul Karim
In the realm of equity options, our study, “A Smiling Bear in the Equity Options Market and the Cross-Section of Stock Returns,” introduces a novel gauge: the convexity of the option-implied volatility curve, termed IV convexity.
Functioning as a forward-looking metric, IV convexity illuminates the anticipated excess tail-risk influence on the perceived variance of underlying equity returns. Scrutinizing individual U.S.-listed stocks from 2000 to 2013, our analysis uncovers a compelling narrative. The average return delta between portfolios in the lowest and highest IV convexity quintiles surpasses 1% per month—a significant revelation both economically and statistically.
This risk-adjusted discrepancy underscores the pivotal role of informed options trading in steering price discovery, specifically in materializing tail-risk aversion within the dynamic landscape of the stock market.
Abstract Of Paper
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Southwestern University of Finance and Economics (SWUFE)
Korea University Business School (KUBS)
In summary, the exploration into the dynamics of the equity options market and its impact on the cross-section of stock returns introduces a novel metric: IV convexity, a forward-looking gauge of excess tail-risk contribution to perceived variance in underlying equity returns.
Leveraging individual U.S.-listed stocks’ options data spanning 2000-2013, our investigation reveals a substantial monthly return differential, exceeding 1%, between portfolios representing the lowest and highest IV convexity quintiles.
This difference holds notable economic and statistical significance, showcasing the relevance of IV convexity as a risk-adjusted measure. The empirical evidence underscores the role of informed options trading in influencing price discovery, particularly in realizing tail-risk aversion within the stock market.
Q1: What is the main focus of the research paper, “A Smiling Bear in the Equity Options Market and the Cross-Section of Stock Returns”?
The research paper explores the concept of IV convexity, which is the convexity of the option-implied volatility curve, as a forward-looking metric to assess the anticipated excess tail-risk influence on the perceived variance of underlying equity returns. The study delves into how this metric, derived from the equity options market, impacts the cross-section of stock returns.
Q2: What is IV convexity, and how does it contribute to the understanding of stock returns?
IV convexity is a measure of excess tail-risk contribution to the perceived variance in underlying equity returns, derived from the option-implied volatility curve. The research reveals that stocks with different IV convexity levels exhibit a substantial monthly return differential, exceeding 1%. This finding suggests that IV convexity serves as a risk-adjusted measure, shedding light on the role of informed options trading in influencing price discovery and tail-risk aversion in the stock market.
Q3: What is the significance of the monthly return differential between low and high IV convexity portfolios?
The observed monthly return differential of over 1% between portfolios representing the lowest and highest IV convexity quintiles is economically and statistically significant. This difference underscores the relevance of IV convexity as a risk-adjusted measure and emphasizes the impact of informed options trading on price discovery in the dynamic landscape of the stock market, particularly in manifesting tail-risk aversion.