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Cross-Sectional Variation of Option-Implied Volatility Skew

Author

Listed:
  • Liuren Wu

    (Zicklin School of Business, Baruch College, The City University of New York, New York, New York 10010)

  • Meng Tian

    (Zicklin School of Business, Baruch College, The City University of New York, New York, New York 10010)

Abstract

The stock option-implied volatility skew reflects both the structural risk characteristics of the underlying company and the short-term information flow about the stock price movement. This paper builds a semistructural, cross-sectional option pricing model to separate the structural risk contributions from the information flow. The model identifies two structural risk sources that contribute to the cross-sectional variation of the skew: the company’s business cyclicality and its default risk. The model can explain as much as 44% of the cross-sectional variation in implied volatility skew and is particularly informative during and after recessions. The remaining skew variation reflects mainly short-term information flow and can be used to construct stock portfolios with much better investment performance and without hidden structural risk exposures.

Suggested Citation

  • Liuren Wu & Meng Tian, 2024. "Cross-Sectional Variation of Option-Implied Volatility Skew," Management Science, INFORMS, vol. 70(6), pages 3566-3580, June.
    • Handle: RePEc:inm:ormnsc:v:70:y:2024:i:6:p:3566-3580
    DOI: 10.1287/mnsc.2023.4872
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    References listed on IDEAS

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