Working Paper: NBER ID: w21161
Authors: George M. Constantinides; Lei Lian
Abstract: We document that the implied volatility skew of S&P 500 index puts is non-decreasing in the disaster index and risk-neutral variance, contrary to the implications of a broad class of no-arbitrage models. The key to the puzzle lies in recognizing that, as the disaster risk increases, customers demand more puts as insurance while market makers become more credit-constrained in writing puts. The resulting increase in the equilibrium price is more pronounced in out-of-the-money than in-the-money puts, thereby steepening the implied volatility skew and resolving the puzzle. Consistent with the data, the model also implies that the equilibrium net buy of puts is decreasing in the disaster index, variance, and their price. The data shows a significant decreasing relationship between the IV skew and the net buy and no relationship in other periods, also explained by the model.
Keywords: S&P 500; put options; implied volatility; disaster risk; market makers
JEL Codes: G10; G12; G13; G23
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased disaster risk (H84) | higher demand for puts (E41) |
| higher demand for puts + supply constraints (J23) | higher equilibrium price for OTM puts (G13) |
| increased perceived risk (D81) | decreasing net buy of puts (G13) |
| increased price of puts (G13) | decreasing net buy of OTM and ATM puts (G13) |
| decreasing net buy of puts (G13) | increasing implied volatility skew during financial crisis (G19) |
| supply constraints + demand pressures (D10) | observed phenomena (C90) |