Stock Return Characteristics, Skew Laws, and the Differential Pricing of Individual Equity Options

TLDR

The article investigates the economic origins and evolution of risk‑neutral skewness in individual equity options, focusing on how risk aversion generates skewness and how return skewness decomposes into systematic and idiosyncratic components. The authors document differential pricing of individual equity options versus the market index, link it to return skewness, demonstrate that risk aversion induces skewness in the risk‑neutral density, and derive laws decomposing skewness into systematic and idiosyncratic parts. Empirical analysis of OEX options and 30 stocks shows that individual risk‑neutral distributions are far less negatively skewed than the market index.

Abstract

This article provides several new insights into the economic sources of skewness. First, we document the differential pricing of individual equity options versus the market index and relate it to variations in return skewness. Second, we show how risk aversion introduces skewness in the risk-neutral density. Third, we derive laws that decompose individual return skewness into a systematic component and an idiosyncratic component. Empirical analysis of OEX options and 30 stocks demonstrates that individual risk-neutral distributions differ from that of the market index by being far less negatively skewed. This article explains the presence and evolution of risk-neutral skewness over time and in the cross section of individual stocks.