Investor sentiment and option prices

This paper examines whether investor sentiment about the stock market affects prices of the S&P 500 options. The findings reveal that the index option volatility smile is steeper (flatter) and the risk-neutral skewness of monthly index return is more (less) negative when market sentiment becomes more bearish (bullish). These significant relations are robust and become stronger when there are more impediments to arbitrage in index options. They cannot be explained by rational perfect-market-based option pricing models. Changes in investor sentiment help explain time variation in the slope of index option smile and risk-neutral skewness beyond factors suggested by the current models. (JEL G12, G13, G14) Jackwerth and Rubinstein (1996) find a pronounced “smile ” effect for S&P 500 options: the Black-Scholes implied volatilities decrease monotonically with the strike price. This is in stark contrast to the Black-Scholes option pricing the-ory under which implied volatilities for options on the same underlying asset should be identical. Generalizations of the Black-Scholes model within the rational representative-agent perfect-market framework can fit the option data better (e.g., Bakshi, Cao, and Chen, 1997; Pan, 2002). However, there are dis