Cross-Sectional Variation of Option-Implied Volatility Skew

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. This paper was accepted by Agostino Capponi, finance. Funding: L. Wu gratefully acknowledges support by a grant from the City University of New York PSC-CUNY Research Award Program. Supplemental Material: The online appendix and data are available at https://doi.org/10.1287/mnsc.2023.4872 .