Downside jump risk and the levels of futures-cash basis

This study investigates the effect of downward market jump risk on the futures-cash basis in the Taiwan stock index futures market. Using the slope of the option implied volatility smirk as a proxy for the risk of large downward price moves, we find that market jump risk helps explain variations in basis. Increased downward jump risk decreases the basis. Indeed, the basis driven by downward jump risk is widened with decreasing time to expiration. After separating downward jump risk into unexpected and expected jump risks, we find that unexpected downward jump risk affects the basis, while no convincing evidence supports the expected downward jump risk effect. The downside jump risk effect is robust even when using the implied volatility skew and the return of a constructed jump risk-mimicking portfolio as proxies for downward jump risk and excluding the sample period from the 2008 financial crisis.