Essays on Financial Derivatives

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2023-08
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Abstract

This dissertation consists of three essays on financial derivatives. The first chapter, Derivative Spreads: Evidence from SPX Options, coauthored with Kris Jacobs and Jie Cao, documents the intraday patterns of spreads, implied volatilities, market order flows, and trading volume. Consistent with the classical models describing dealer trading behavior, we find a significantly positive relationship between volatilities and SPX options spreads. A positive relationship between the deviation from balanced buy-sell orders from end-users and SPX options spreads before market close is also found, coherent with inventory control models. However, we observe a diminishing pattern of the impact of end-user demands near market close, which dealer market power models can explain. We also report a negative relationship between spreads and supply imbalances. The second chapter, Tail Risk around FOMC Announcements, coauthored with Kris Jacobs and Xuhui (Nick) Pan, shows that tail risks play an important role in understanding the market risk premium around FOMC announcement days by predictive regressions of returns on (abnormal) option-implied moments measured before pre-scheduled FOMC meetings. While volatility predicts the pre-FOMC drift and the announcement day market returns, skewness and kurtosis, which capture investors’ expectation of the tails of the return distribution, robustly predict post-FOMC returns both in-sample and out-of-sample. The predictability lasts up to one week and is stronger when the monetary policy shock is expansionary or when the FOMC announcement is not accompanied by a press conference. The tail risks are embedded in pre-FOMC out-of-the-money put prices used by investors to hedge against adverse states of the economy. The third chapter, Risk-Neutral Higher Moments and the Cross-Section of Stock Returns, examines the pricing of risk-neutral moments in the cross-section of stock returns. Contradicting theory predictions, stocks with high option-implied skewness have empirically high average returns. While stocks with high option-implied volatility have high average returns, stocks with high option-implied kurtosis tend to have low returns. The moment-return relationship is persistent across options maturity and stock holding period. The skewness-return relationship is observed among all firms, but the negative kurtosis-return relationship is driven by firms with high volatility, low market value, and high illiquidity.

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Options, Volatility, Skewness, Kurtosis
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