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A Smiling Bear in the Equity Options Market and the Cross-Section of Stock Returns

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

Here you can download the PDF and original paper of A Smiling Bear in the Equity Options Market and the Cross-Section of Stock Returns.

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Author

Hye-hyun Park
Southwestern University of Finance and Economics (SWUFE)

Baeho Kim
Korea University Business School (KUBS)

Hyeongsop Shim
Gachon University

Conclusion

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.

Related Reading:

Overnight Return, the Invisible Hand Behind The Intraday Return? A Retrospective

A Survey of Day of the Month Effect in World Stock Markets

FAQ

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.

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