No CrossRef data available.
Article contents
Does the Options Market Underreact to Firms’ Left-Tail Risk?
Published online by Cambridge University Press: 15 April 2024
Abstract
Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.
We show that firms’ left-tail risk positively predicts future returns of crash insurance. We proxy crash insurance with bear spreads, an option trading strategy that profits when extreme negative returns occur. Crash insurance for high (low) left-tail risk firms earns positive (negative) returns, suggesting that the downside protection it provides is not adequately priced. Our results are mainly explained by two types of underreaction: volatility underreaction in high left-tail risk portfolios and underreaction to the persistence of left-tail risk. Disagreement partially explains our results, but a risk-based approach does not.
- Type
- Research Article
- Information
- Creative Commons
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.- Copyright
- © The Author(s), 2024. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington
Footnotes
The authors thank an anonymous referee and Jennifer Conrad (the editor) for their very helpful comments, which greatly improved the article. The authors also thank seminar participants at Tongji University, University of Sydney, and ITAM; conference participants of the Cancun Derivatives Workshop 2022, 2023 EFMA Annual Meetings, and 2023 FMA Annual Meetings; and Diego Amaya, Heiner Beckmeyer, Michael Johannes, Andrea Lu, Neil Pearson, Thuy To, and Chu Zhang for helpful comments. Vasquez thanks the Asociación Mexicana de Cultura A.C. for financial support. All errors are our own.
References
Acharya, V., and Naqvi, H.. “On Reaching for Yield and the Coexistence of Bubbles and Negative Bubbles.” Journal of Financial Intermediation, 38 (2019), 1–10.CrossRefGoogle Scholar
Amihud, Y. “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects.” Journal of Financial Markets, 5 (2002), 31–56.CrossRefGoogle Scholar
Ang, A.; Chen, J.; and Xing, Y.. “Downside Risk.” Review of Financial Studies, 19 (2006), 1191–1239.CrossRefGoogle Scholar
Asparouhova, E.; Bessembinder, H.; and Kalcheva, I.. “Noisy Prices and Inference Regarding Returns.” Journal of Finance, 68 (2013), 665–714.CrossRefGoogle Scholar
Atilgan, Y.; Bali, T. G.; Demirtas, K. O.; and Gunaydin, A. D.. “Left-Tail Momentum: Underreaction to Bad News, Costly Arbitrage and Equity Returns.” Journal of Financial Economics, 135 (2020), 725–753.CrossRefGoogle Scholar
Baker, M., and Wurgler, J.. “Investor Sentiment and the Cross-Section of Stock Returns.” Journal of Finance, 61 (2006), 1645–1680.CrossRefGoogle Scholar
Bakshi, G.; Kapadia, N.; and Madan, D.. “Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options.” Review of Financial Studies, 16 (2003), 101–143.CrossRefGoogle Scholar
Bali, T. G., and Murray, S.. “Does Risk-Neutral Skewness Predict the Cross Section of Equity Option Portfolio Returns?” Journal of Financial and Quantitative Analysis, 48 (2013), 1145–1171.CrossRefGoogle Scholar
Baltussen, G.; Van Bekkum, S.; and Van Der Grient, B.. “Unknown Unknowns: Uncertainty About Risk and Stock Returns.” Journal of Financial and Quantitative Analysis, 53 (2018), 1615–1651.CrossRefGoogle Scholar
Barberis, N.; Shleifer, A.; and Vishny, R.. “A Model of Investor Sentiment.” Journal of Financial Economics, 49 (1998), 307–343.CrossRefGoogle Scholar
Barrero, J. M. “The Micro and Macro of Managerial Beliefs.” Journal of Financial Economics, 143 (2022), 640–667.CrossRefGoogle Scholar
Berkelaar, A. B.; Kouwenberg, R.; and Post, T.. “Optimal Portfolio Choice Under Loss Aversion.” Review of Economics and Statistics, 86 (2004), 973–987.CrossRefGoogle Scholar
Boehme, R. D.; Danielsen, B. R.; and Sorescu, S. M.. “Short-Sale Constraints, Differences of Opinion, and Overvaluation.” Journal of Financial and Quantitative Analysis, 41 (2006), 455–487.CrossRefGoogle Scholar
Bollen, N. P., and Whaley, R. E.. “Does Net Buying Pressure Affect the Shape of Implied Volatility Functions?” Journal of Finance, 59 (2004), 711–753.CrossRefGoogle Scholar
Brennan, M. J.; Chordia, T.; and Subrahmanyam, A.. “Alternative Factor Specifications, Security Characteristics, and the Cross-Section of Expected Stock Returns.” Journal of Financial Economics, 49 (1998), 345–373.CrossRefGoogle Scholar
Byun, S.-J., and Kim, D.-H.. “Gambling Preference and Individual Equity Option Returns.” Journal of Financial Economics, 122 (2016), 155–174.CrossRefGoogle Scholar
Campbell, J. Y.; Hilscher, J.; and Szilagyi, J.. “In Search of Distress Risk.” Journal of Finance, 63 (2008), 2899–2939.CrossRefGoogle Scholar
Cao, J., and Han, B.. “Cross Section of Option Returns and Idiosyncratic Stock Volatility.” Journal of Financial Economics, 108 (2013), 231–249.CrossRefGoogle Scholar
Cao, J. J.; Vasquez, A.; Xiao, X.; and Zhan, X. E.. “Why Does Volatility Uncertainty Predict Equity Option Returns?” Quarterly Journal of Finance, 13 (2023), 2350005.CrossRefGoogle Scholar
Carhart, M. M. “On Persistence in Mutual Fund Performance.” Journal of Finance, 52 (1997), 57–82.CrossRefGoogle Scholar
Chabi-Yo, F.; Ruenzi, S.; and Weigert, F.. “Crash Sensitivity and Cross-Section of Expected Stock Returns.” Journal of Financial and Quantitative Analysis, 53 (2018), 1059–1100.CrossRefGoogle Scholar
Chan, W. S. “Stock Price Reaction to News and No-News: Drift and Reversal After Headlines.” Journal of Financial Economics, 70 (2003), 223–260.CrossRefGoogle Scholar
Chatterjee, S.; John, K.; and Yan, A.. “Takeovers and Divergence of Investor Opinion.” Review of Financial Studies, 25 (2012), 227–277.CrossRefGoogle Scholar
Chen, B.; Gan, Q.; and Vasquez, A.. “Anticipating Jumps: Decomposition of Straddle Price.” Journal of Banking & Finance, 149 (2023), 106755.CrossRefGoogle Scholar
Cheng, I.-H. “Volatility Markets Underreacted to the Early Stages of the COVID-19 Pandemic.” Review of Asset Pricing Studies, 10 (2020), 635–668.CrossRefGoogle Scholar
Corsi, F. “A Simple Approximate Long-Memory Model of Realized Volatility.” Journal of Financial Econometrics, 7 (2009), 174–196.CrossRefGoogle Scholar
Coval, J. D., and Shumway, T.. “Expected Option Returns.” Journal of Finance, 56 (2001), 983–1009.CrossRefGoogle Scholar
Cremers, M.; Halling, M.; and Weinbaum, D.. “Aggregate Jump and Volatility Risk in the Cross-Section of Stock Returns.” Journal of Finance, 70 (2015), 577–614.CrossRefGoogle Scholar
Daniel, K. D.; Hirshleifer, D.; and Subrahmanyam, A.. “Overconfidence, Arbitrage, and Equilibrium Asset Pricing.” Journal of Finance, 56 (2001), 921–965.CrossRefGoogle Scholar
Diether, K. B.; Malloy, C. J.; and Scherbina, A.. “Differences of Opinion and the Cross Section of Stock Returns.” Journal of Finance, 57 (2002), 2113–2141.CrossRefGoogle Scholar
Driessen, J.; Lin, T.-C.; and Van Hemert, O.. “How the 52-Week High and Low Affect Option-Implied Volatilities and Stock Return Moments.” Review of Finance, 17 (2013), 369–401.CrossRefGoogle Scholar
Driessen, J.; Maenhout, P. J.; and Vilkov, G.. “The Price of Correlation Risk: Evidence from Equity Options.” Journal of Finance, 64 (2009), 1377–1406.CrossRefGoogle Scholar
Easterwood, J. C., and Nutt, S. R.. “Inefficiency in Analysts’ Earnings Forecasts: Systematic Misreaction or Systematic Optimism?” Journal of Finance, 54 (1999), 1777–1797.CrossRefGoogle Scholar
Fama, E. F., and French, K. R.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 3–56.CrossRefGoogle Scholar
Fama, E. F., and MacBeth, J. D.. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy, 81 (1973), 607–636.CrossRefGoogle Scholar
Gao, C.; Xing, Y.; and Zhang, X.. “Anticipating Uncertainty: Straddles Around Earnings Announcements.” Journal of Financial and Quantitative Analysis, 53 (2018), 2587–2617.CrossRefGoogle Scholar
George, T. J., and Hwang, C.-Y.. “The 52-Week High and Momentum Investing.” Journal of Finance, 59 (2004), 2145–2176.CrossRefGoogle Scholar
Goyal, A., and Saretto, A.. “Cross-Section of Option Returns and Volatility.” Journal of Financial Economics, 94 (2009), 310–326.CrossRefGoogle Scholar
Han, B. “Investor Sentiment and Option Prices.” Review of Financial Studies, 21 (2008), 387–414.CrossRefGoogle Scholar
Harvey, C. R., and Siddique, A.. “Time-Varying Conditional Skewness and the Market Risk Premium.” Research in Banking and Finance, 1 (2000), 27–60.Google Scholar
Heston, S. L.; Jones, C. S.; Khorram, M.; Li, S.; and Mo, H.. “Option Momentum.” Journal of Finance, 78 (2023), 3141–3192.CrossRefGoogle Scholar
Hirshleifer, D., and Teoh, S. H.. “Limited Attention, Information Disclosure, and Financial Reporting.” Journal of Accounting and Economics, 36 (2003), 337–386.CrossRefGoogle Scholar
Hong, H.; Lim, T.; and Stein, J. C.. “Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies.” Journal of Finance, 55 (2000), 265–295.CrossRefGoogle Scholar
Hong, H., and Stein, J. C.. “A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets.” Journal of Finance, 54 (1999), 2143–2184.CrossRefGoogle Scholar
Horenstein, A. R.; Vasquez, A.; and Xiao, X.. “Common Factors in Equity Option Returns.” Working Paper (2022).Google Scholar
Jarrow, R., and Zhao, F.. “Downside Loss Aversion and Portfolio Management.” Management Science, 52 (2006), 558–566.CrossRefGoogle Scholar
Jiang, G.; Lee, C. M.; and Zhang, Y.. “Information Uncertainty and Expected Returns.” Review of Accounting Studies, 10 (2005), 185–221.CrossRefGoogle Scholar
Jin, W.; Livnat, J.; and Zhang, Y.. “Option Prices Leading Equity Prices: Do Option Traders Have an Information Advantage?” Journal of Accounting Research, 50 (2012), 401–432.CrossRefGoogle Scholar
Kahneman, D., and Tversky, A.. “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica, 47 (1979), 263–292.CrossRefGoogle Scholar
Kelly, B., and Jiang, H.. “Tail Risk and Asset Prices.” Review of Financial Studies, 27 (2014), 2841–2871.CrossRefGoogle Scholar
Kelly, B.; Lustig, H.; and Van Nieuwerburgh, S.. “Too-Systemic-to-Fail: What Option Markets Imply About Sector-Wide Government Guarantees.” American Economic Review, 106 (2016a), 1278–1319.CrossRefGoogle Scholar
Kelly, B.; Pástor, L.; and Veronesi, P.. “The Price of Political Uncertainty: Theory and Evidence from the Option Market.” Journal of Finance, 71 (2016b), 2417–2480.CrossRefGoogle Scholar
Kumar, A. “Hard-to-Value Stocks, Behavioral Biases, and Informed Trading.” Journal of Financial and Quantitative Analysis, 44 (2009), 1375–1401.CrossRefGoogle Scholar
Lemmon, M., and Ni, S. X.. “Differences in Trading and Pricing Between Stock and Index Options.” Management Science, 60 (2014), 1985–2001.CrossRefGoogle Scholar
Lochstoer, L. A., and Muir, T.. “Volatility Expectations and Returns.” Journal of Finance, 77 (2022), 1055–1096.CrossRefGoogle Scholar
Lu, Z., and Murray, S.. “Bear Beta.” Journal of Financial Economics, 131 (2019), 736–760.CrossRefGoogle Scholar
Muravyev, D. “Order Flow and Expected Option Returns.” Journal of Finance, 71 (2016), 673–708.CrossRefGoogle Scholar
Muravyev, D., and Pearson, N. D.. “Options Trading Costs Are Lower Than You Think.” Review of Financial Studies, 33 (2020), 4973–5014.CrossRefGoogle Scholar
Newey, W. K., and West, K. D.. “A Simple, Positive Semi-Definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix.” Econometrica, 55 (1987), 703–708.CrossRefGoogle Scholar
Poteshman, A. M. “Underreaction, Overreaction, and Increasing Misreaction to Information in the Options Market.” Journal of Finance, 56 (2001), 851–876.CrossRefGoogle Scholar
Stambaugh, R. F.; Yu, J.; and Yuan, Y.. “The Short of It: Investor Sentiment and Anomalies.” Journal of Financial Economics, 104 (2012), 288–302.CrossRefGoogle Scholar
Tversky, A., and Kahneman, D.. “Loss Aversion in Riskless Choice: A Reference-Dependent Model.” Quarterly Journal of Economics, 106 (1991), 1039–1061.CrossRefGoogle Scholar
Van Oordt, M., and Zhou, C.. “Systematic Tail Risk.” Journal of Financial and Quantitative Analysis, 51 (2016), 685–705.CrossRefGoogle Scholar
Vanden, J. M. “Option Coskewness and Capital Asset Pricing.” Review of Financial Studies, 19 (2006), 1279–1320.CrossRefGoogle Scholar
Vasquez, A. “Equity Volatility Term Structures and the Cross Section of Option Returns.” Journal of Financial and Quantitative Analysis, 52 (2017), 2727–2754.CrossRefGoogle Scholar
Vasquez, A., and Xiao, X.. “Default Risk and Option Returns.” Management Science, 70 (2024), 2144–2167.CrossRefGoogle Scholar
Weinbaum, D.; Fodor, A.; Muravyev, D.; and Cremers, M.. “Option Trading Activity, News Releases, and Stock Return Predictability.” Management Science, 69 (2023), 4810–4827.CrossRefGoogle Scholar
Xing, Y.; Zhang, X.; and Zhao, R.. “What Does the Individual Option Volatility Smirk Tell Us About Future Equity Returns?” Journal of Financial and Quantitative Analysis, 45 (2010), 641–662.CrossRefGoogle Scholar
Yu, J. “Disagreement and Return Predictability of Stock Portfolios.” Journal of Financial Economics, 99 (2011), 162–183.CrossRefGoogle Scholar
Yu, J., and Yuan, Y.. “Investor Sentiment and the Mean–Variance Relation.” Journal of Financial Economics, 100 (2011), 367–381.CrossRefGoogle Scholar
Zhan, X.; Han, B.; Cao, J.; and Tong, Q.. “Option Return Predictability.” Review of Financial Studies, 35 (2022), 1394–1442.CrossRefGoogle Scholar
Zhang, X. F. “Information Uncertainty and Analyst Forecast Behavior.” Contemporary Accounting Research, 23 (2006a), 565–590.CrossRefGoogle Scholar
Zhang, X. F. “Information Uncertainty and Stock Returns.” Journal of Finance, 61 (2006b), 105–137.CrossRefGoogle Scholar
Chen et al. supplementary material
Chen et al. supplementary material
File
264 KB
You have
Access
Open access