Effects of Market Default Risk on Index Options Risk-Neutral Moments

Abstract

This paper examines the time series economic determinants of Standard & Poor’s (S&P) 500 Index option-implied risk-neutral distributions for the period 1998–2007. In particular, we investigate the effects of a market default likelihood index, which is computed by aggregating daily default risk measures for all individual, non-financial firms included in the S&P 500 Index portfolio. The results reveal that market default risk is positively (negatively) related to the index risk-neutral volatility and skewness (kurtosis). Moreover, the findings of this study illuminate a set of economic determinants relating to the characteristics of the underlying asset and microstructure variables characterizing the option market, which are also found to affect the index option-implied risk-neutral moments. Overall, our findings provide a better understanding of what drives the daily shapes of the S&P 500 option-implied risk-neutral distributions and offer explanations of why theoretical predictions of rational option pricing models are not consistent with what is observed in practice.

Keywords: default risk, implied volatility smirk, deterministic volatility functions, determinants, trading volume

JEL Classification: G12, G13, G14