Political uncertainty and the information content of options trading

This thesis analyses the information content of options in predicting stock market returns during periods of heightened political uncertainty. Motivated by the option pricing model of Kelly, Pástor, and Veronesi (2016), we examine the predictive power of volatility spread on S&P 500 stock market returns during periods of major U.S. political and economic events. In contrast to prior evidence that option volatility spread strongly predicts stock market returns, we find that volatility spread contains little information in predicting stock returns during heightened uncertainty around important political events. We examine the drivers of volatility spread preceding political events and ascribe the breakdown in the volatility spreadreturn relationship to unsophisticated investor demand and political uncertainty. We find that both political uncertainty and unsophisticated investor demand drive increases in volatility spread preceding political events, but there is no significant relationship between volatility spread and sophisticated investor demand over this period. Overall, this thesis contributes to the extant literature by integrating demand-based explanations of volatility spread with the growing literature on the implications of political uncertainty for the option and stock markets. We quantify the relative importance of both political uncertainty and option demand for volatility spread prior to political events, and relate this to the information content of volatility spread for future stock market returns. We also show a probable breakdown in the relationship between volatility spread and stock market returns prior to political events, and contribute to the literature by highlighting a limitation in using this option-signal for future stock market returns. Finally, we provide additional empirical support to the option pricing model of Kelly et al. (2016) and suggest avenues of future research to further assess the relationship between political uncertainty and the predictive information content of options on stock returns