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Time-Varying Crash Risk Embedded in Index Options: The Role of Stock Market Liquidity
[Does realized skewness predict the cross-section of equity returns?]

Author

Listed:
  • Peter Christoffersen
  • Bruno Feunou
  • Yoontae Jeon
  • Chayawat Ornthanalai

Abstract

We estimate a continuous-time model for the stock market index where the stochastic volatility and crash probability depend on the realized spot variance and the stock market illiquidity. We find that market illiquidity is a useful economic covariate in the modeling of time-varying stock market crash risk embedded in index options. The relative contribution of spot variance in the time-varying crash risk is weakened once the market illiquidity variable is added to the model, and out-of-sample option pricing error also improves. Examining the relationship between market illiquidity and option-implied crash risk, we find that the availability of arbitrage capital and adverse selection facing liquidity providers are potential economic links. Our study highlights the benefits of adding a market illiquidity measure to index return models with time-varying crash risk.

Suggested Citation

  • Peter Christoffersen & Bruno Feunou & Yoontae Jeon & Chayawat Ornthanalai, 2021. "Time-Varying Crash Risk Embedded in Index Options: The Role of Stock Market Liquidity [Does realized skewness predict the cross-section of equity returns?]," Review of Finance, European Finance Association, vol. 25(4), pages 1261-1298.
    • Handle: RePEc:oup:revfin:v:25:y:2021:i:4:p:1261-1298.
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    File URL: http://hdl.handle.net/10.1093/rof/rfaa040
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    Citations

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    Cited by:

    1. Chavas, Jean-Paul & Li, Jian & Wang, Linjie, 2024. "Option pricing revisited: The role of price volatility and dynamics," Journal of Commodity Markets, Elsevier, vol. 33(C).
    2. Chavas, Jean-Paul & Li, Jian & Wang, Linjie, 2024. "Option Pricing Revisited: The Role of Price Volatility and Dynamics," 2024 Annual Meeting, July 28-30, New Orleans, LA 343544, Agricultural and Applied Economics Association.

    More about this item

    Keywords

    Option-implied crash risk; Market liquidity; Jump intensity; Filtering;
    All these keywords.

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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