Template-Type: ReDIF-Paper 1.0
Series: Tinbergen Institute Discussion Papers
Creation-Date: 2017-01-13
Revision-Date: 2018-01-26
Number: 17-002/IV
Author-Name: Philip Stork
Author-Workplace-Name: VU Amsterdam, The Netherlands
Author-Name: Luiz Felix
Author-Workplace-Name: VU Amsterdam, The Netherlands
Author-Name: Roman Kraussl
Author-Workplace-Name: University of Luxembourg, Luxembourg
Title: Implied Volatility Sentiment: A Tale of Two Tails
Abstract: Low probability events are overweighted in the pricing of out-of-the-money index puts and single stock calls. We show that such a behavioral bias is strongly time-varying and is linked to equity market sentiment and higher moments of the risk-neutral density. We find that our implied volatility (IV) sentiment measure, jointly derived from index and single stock options, explains investors' overweight of tail events well. Our IV-sentiment measure adds value over and above traditional factors in predicting the equity risk premium out-of-sample. When employed as a mean-reversion strategy, our IV-sentiment measure delivers economically significant results, which are more consistent than the ones produced by the conventional sentiment factor. We find that our contrarian investment strategy shows limited exposure to a set of cross-sectional equity factors, including Fama and French's five factors, the momentum factor and the low-volatility factor, and seems valuable in avoiding momentum crashes.
Classification-JEL: G12, G14, G17.
Keywords: Sentiment, implied volatility skew, equity-risk premium, reversals, predictability.
File-Url: https://papers.tinbergen.nl/17002.pdf
File-Format: application/pdf
File-Size: 670076 bytes
Handle: RePEc:tin:wpaper:20170002