Investor Sentiments, Rational Beliefs and Option Prices

This paper explores the impact of investor sentiment on the risk-neutral skewness of S&P 500 index options over the period 1990 to 2011. We decompose the aggregate investor sentiment into an economic fundamentals component that captures investors rational updating of beliefs and an error in beliefs component that captures investors expectations not associated with the economic conditions. Our \u85ndings reveal a tale of two periods: before June 1997 both the sentiment components a¤ect risk-neutral skewness, while after June 1997 only the fundamentals component is able to explain risk-neutral skewness. Furthermore, the e¤ect of the fundamentals is more pronounced in periods of worsened stock market conditions. By estimating di¤erent measures of the slope of the implied volatility smirk, we show that the slope of the callsimplied volatility smirk is driven by investors expectations about a continuation of recent economic conditions, while the slope of the putsimplied volatility smirk is driven by investorsexpectations about a reversal in the economy. Overall, our results highlight the importance of economic fundamentals for explaining the variations in option prices and the pricing kernel. JEL Classi\u85cation: G12, G1