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Does the Options Market Underreact to Firms’ Left-Tail Risk?

Published online by Cambridge University Press:  15 April 2024

Bei Chen ,
Quan Gan Open the ORCID record for Quan Gan [Opens in a new window]  and
Aurelio Vasquez
Bei Chen
Affiliation:
Shanghai International Studies University School of Business and Management beichen.finance@shisu.edu.cn
Quan Gan*
Affiliation:
The University of Sydney Business School
Aurelio Vasquez
Affiliation:
ITAM Business School aurelio.vasquez@itam.mx
*
quan.gan@sydney.edu.au (corresponding author)
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Abstract

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We show that firms’ left-tail risk positively predicts future returns of crash insurance. We proxy crash insurance with bear spreads, an option trading strategy that profits when extreme negative returns occur. Crash insurance for high (low) left-tail risk firms earns positive (negative) returns, suggesting that the downside protection it provides is not adequately priced. Our results are mainly explained by two types of underreaction: volatility underreaction in high left-tail risk portfolios and underreaction to the persistence of left-tail risk. Disagreement partially explains our results, but a risk-based approach does not.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , First View , pp. 1 - 32
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2024. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

The authors thank an anonymous referee and Jennifer Conrad (the editor) for their very helpful comments, which greatly improved the article. The authors also thank seminar participants at Tongji University, University of Sydney, and ITAM; conference participants of the Cancun Derivatives Workshop 2022, 2023 EFMA Annual Meetings, and 2023 FMA Annual Meetings; and Diego Amaya, Heiner Beckmeyer, Michael Johannes, Andrea Lu, Neil Pearson, Thuy To, and Chu Zhang for helpful comments. Vasquez thanks the Asociación Mexicana de Cultura A.C. for financial support. All errors are our own.

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