Abstract
This thesis comprises four papers focusing on options. It includes studies on the pricing of uncertainty associated with the COVID-19 cases/deaths in China (Chapter 2), the relation between the implied volatility (IV) smirk and subsequent equity returns for individual stock options (Chapter 3), the pricing of uncertainty associated with policies and announcements on the COVID-19 pandemic worldwide (Chapter 4), and the relationship between the cost of option insurance against downside tail risks and firm exposure to COVID-19 (Chapter 5).
In Chapter 2, we investigate the pricing of uncertainty associated with COVID-19 in China in early 2020. We show that the implied volatility slope (Slope) measure, which captures the relative cost of protection against extreme downside tail risk in the CSI 300 Index Options market, is positively related to new cases and deaths of the pandemic during the COVID-19 outbreak in China, as opposed to that during the post-pandemic period after the Chinese government officially lifted the lockdown. It suggests that COVID-19 did cause investors’ fear of crash risk in the Chinese option market.
Chapter 3 examines the relation between the implied volatility (IV) smirk and subsequent stock returns for individual stock options in the U.S. We decompose IV of the equity options using a quadratic function and obtain the level (LEVEL), slope (SLOPE), and curvature (CURV), variations of which correspond to changes of investors' demand. Our empirical results show that LEVEL, SLOPE, and CURV all have a negative cross-sectional relation with future monthly stock returns from 1996 to 2019, suggesting more (less) speculating demand, more (less) hedging demand, and more aggressive speculating demand for options when investors are informed of lower (higher) future stock returns, respectively.
In Chapter 4, we further extend the research in In Chapter 2 and investigate the pricing of uncertainty associated with the COVID-19 responses for 28 countries/regions. We find that the investors demand compensation in taking on the uncertainty induced by the COVID-19 responses and pay a price premium to buy the option insurance against such uncertainty in the options market. Chapter 5 takes the COVID research one step forward and tests the option investors’ reaction to COVID-19 uncertainty in the cross-section. We find that the cost of option protection against downside tail risks is larger when the firms are exposed less to the COVID-19 pandemic in 2020 and 2021.