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Does net buying pressure affect the shape of implied volatility functions
 Journal of Finance
, 2004
"... This paper examines the relation between net buying pressure and the shape of the implied volatility function (IVF) for index and individual stock options. We find that changes in implied volatility are directly related to net buying pressure from public order flow. We also find that changes in impl ..."
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Cited by 144 (3 self)
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This paper examines the relation between net buying pressure and the shape of the implied volatility function (IVF) for index and individual stock options. We find that changes in implied volatility are directly related to net buying pressure from public order flow. We also find that changes in implied volatility of S&P 500 options are most strongly affected by buying pressure for index puts, while changes in implied volatility of stock options are dominated by call option demand. Simulated deltaneutral optionwriting trading strategies generate abnormal returns that match the deviations of the IVFs above realized historical return volatilities. If people are willing to pay foolish prices for insurance, why shouldn’t we sell it to them? (Lowenstein (2000)). ONE OF THE MOST INTRIGUING ANOMALIES REPORTED in the derivatives literature is the “implied volatility smile. ” The name arose from the fact that, prior to the October 1987 market crash, the relation between the Black and Scholes (1973) implied volatility of S&P 500 index options and exercise price gave the ap
DeltaHedged Gains and the Negative Market Volatility Risk Premium
 The Review of Financial Studies
, 2001
"... We investigate whether the volatility risk premium is negative by examining the statistical properties of deltahedged option portfolios (buy the option and hedge with stock). Within a stochastic volatility framework, we demonstrate a correspondence between the sign and magnitude of the volatility r ..."
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Cited by 118 (5 self)
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We investigate whether the volatility risk premium is negative by examining the statistical properties of deltahedged option portfolios (buy the option and hedge with stock). Within a stochastic volatility framework, we demonstrate a correspondence between the sign and magnitude of the volatility risk premium and the mean deltahedged portfolio returns. Using a sample of S&P 500 index options, we provide empirical tests that have the following general results. First, the deltahedged strategy underperforms zero. Second, the documented underperformance is less for options away from the money. Third, the underperformance is greater at times of higher volatility.Fourth, the volatility risk premium significantly affects deltahedged gains even after accounting for jumpfears. Our evidence is supportive of a negative market volatility risk premium.
The price of correlation risk: Evidence from equity options
 Journal of Finance, 64(3):1377
"... We study whether exposure to marketwide correlation shocks affects expected option returns, using data on S&P100 index options, options on all components, and stock returns. We find evidence of priced correlation risk based on prices of index and individual variance risk. A trading strategy exp ..."
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Cited by 34 (5 self)
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We study whether exposure to marketwide correlation shocks affects expected option returns, using data on S&P100 index options, options on all components, and stock returns. We find evidence of priced correlation risk based on prices of index and individual variance risk. A trading strategy exploiting priced correlation risk generates a high alpha and is attractive for CRRA investors without frictions. Correlation risk exposure explains the crosssection of index and individual option returns well. The correlation risk premium cannot be exploited with realistic trading frictions, providing a limitstoarbitrage interpretation of our finding of a high price of correlation risk. CORRELATIONS PLAY A CENTRAL ROLE in financial markets. There is considerable evidence that correlations between asset returns change over time1 and that stock return correlations increase when returns are low.2 A marketwide increase in correlations negatively affects investor welfare by lowering diversification benefits and by increasing market volatility, so that states of nature with unusually high correlations may be expensive. It is therefore natural to ask whether marketwide correlation risk is priced in the sense that assets that pay off well when marketwide correlations are higher than expected (thereby providing a ∗Driessen is at the University of Amsterdam. Maenhout and Vilkov are at INSEAD. We would
Understanding the Role of Recovery in Default Risk Models: Empirical Comparisons and Implied Recovery Rates
, 2006
"... This article presents a framework for studying the role of recovery on defaultable debt prices for a wide class of processes describing recovery rates and default probability. These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be employe ..."
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Cited by 34 (0 self)
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This article presents a framework for studying the role of recovery on defaultable debt prices for a wide class of processes describing recovery rates and default probability. These debt models have the ability to differentiate the impact of recovery rates and default probability, and can be employed to infer the market expectation of recovery rates implicit in bond prices. Empirical implementation of these models suggests two central findings. First, the recovery concept that specifies recovery as a fraction of the discounted par value has broader empirical support. Second, parametric debt valuation models can provide a useful assessment of recovery rates embedded in bond prices.
Stochastic risk premiums, stochastic skewness in currency options, and stochastic discount factors in international economies
 Journal of Financial Economics
, 2007
"... We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using timeseries returns and option prices on three currency pairs that form a triangular relation. Estimation shows ..."
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Cited by 29 (3 self)
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We develop models of stochastic discount factors in international economies that produce stochastic risk premiums and stochastic skewness in currency options. We estimate the models using timeseries returns and option prices on three currency pairs that form a triangular relation. Estimation shows that the average risk premium in Japan is larger than that in the US or the UK, the global risk premium is more persistent and volatile than the countryspecific risk premiums, and investors respond differently to different shocks. We also identify highfrequency jumps in each economy, but find that only downside jumps are priced. Finally, our analysis shows that the risk premiums are economically compatible with movements in stock and bond market fundamentals.
Investor sentiment and option prices
 Review of Financial Studies
, 2008
"... This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. The findings reveal that the index option volatility smile is steeper (flatter) and the riskneutral skewness of monthly index return is more (less) negative when market sentiment becomes ..."
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Cited by 27 (1 self)
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This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. The findings reveal that the index option volatility smile is steeper (flatter) and the riskneutral skewness of monthly index return is more (less) negative when market sentiment becomes more bearish (bullish). These significant relations are robust and become stronger when there are more impediments to arbitrage in index options. They cannot be explained by rational perfectmarketbased option pricing models. Changes in investor sentiment help explain time variation in the slope of index option smile and riskneutral skewness beyond factors suggested by the current models. (JEL G12, G13, G14) Jackwerth and Rubinstein (1996) find a pronounced “smile ” effect for S&P 500 options: the BlackScholes implied volatilities decrease monotonically with the strike price. This is in stark contrast to the BlackScholes option pricing theory under which implied volatilities for options on the same underlying asset should be identical. Generalizations of the BlackScholes model within the rational representativeagent perfectmarket framework can fit the option data better (e.g., Bakshi, Cao, and Chen, 1997; Pan, 2002). However, there are dis
Closedform transformations from risk neutral to realworld distributions
 Journal of Banking and Finance
, 2007
"... Riskneutral (RN) and realworld (RW) densities are derived from option prices and risk assumptions, and are compared with densities obtained from historical time series. Two parametric methods that adjust from RN to RW densities are investigated, firstly a CRRA risk aversion transformation and seco ..."
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Cited by 24 (6 self)
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Riskneutral (RN) and realworld (RW) densities are derived from option prices and risk assumptions, and are compared with densities obtained from historical time series. Two parametric methods that adjust from RN to RW densities are investigated, firstly a CRRA risk aversion transformation and secondly a statistical calibration. Both risk transformations are estimated using likelihood techniques, for two flexible but tractable density families. Results for the FTSE100 index show that densities derived from option prices have more explanatory power than historical time series. Furthermore, the pricing kernel between RN & RW densities may be more regular than previously reported and a more reasonable risk aversion function is estimated. 2 Closedform Transformations from Riskneutral to Realworld Distributions 1.
2008): “State dependence can explain the risk aversion puzzle,”Review of Financial Studies
"... Risk aversion functions extracted from observed stock and option prices can be negative, ..."
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Cited by 23 (2 self)
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Risk aversion functions extracted from observed stock and option prices can be negative,
Failure is an Option: Impediments to Short Selling and Options Prices, working paper
, 2003
"... Regulations allow market makers to short sell without borrowing stock, and the transactions of a major options market maker show that in most hardtoborrow situations, it chooses not to borrow and instead fails to deliver stock to its buyers. Some of the value of failing passes through to option pr ..."
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Cited by 22 (3 self)
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Regulations allow market makers to short sell without borrowing stock, and the transactions of a major options market maker show that in most hardtoborrow situations, it chooses not to borrow and instead fails to deliver stock to its buyers. Some of the value of failing passes through to option prices: when failing is cheaper than borrowing, the relation between borrowing costs and option prices is significantly weaker. The remaining value is profit to the market maker, and its ability to profit despite the usual competition between market makers appears to result from a cost advantage of larger market makers at failing.
The effect of macroeconomic news on beliefs and preferences: evidence from the options market. NBER Working Paper Series
, 2003
"... We examine the effect of regularly scheduled macroeconomic announcements on the beliefs and preferences of participants in the U.S. Treasury market by comparing the optionimplied stateprice density (SPD) of bond prices shortly before and after the announcements. We find that the announcements redu ..."
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Cited by 19 (2 self)
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We examine the effect of regularly scheduled macroeconomic announcements on the beliefs and preferences of participants in the U.S. Treasury market by comparing the optionimplied stateprice density (SPD) of bond prices shortly before and after the announcements. We find that the announcements reduce the uncertainty implicit in the second moment of the SPD regardless of the content of the news. The changes in the higherorder moments, in contrast, depend on whether the news is good or bad for economic prospects. Using a standard model for interest rates to disentangle changes in beliefs and changes in preferences, we demonstrate that our results are consistent with timevarying risk aversion in the spirit of habit formation. We thank Tim Bollerslev, Jun Cai, and Frank Song for providing the announcements data and Nick