Subjective Expectations for Variance and Skewness: Evidence from Analyst Forecasts, with Shuaiyu Chen, and Yucheng Yang
We propose novel firm-level measures for subjective expectations on variance and skewness derived from analysts' price forecast ranges in their research reports. We find that analyst expectations positively predict future variance and skewness of stock return, even after controlling for corresponding option-implied moments and past realized moments. Moreover, analyst variance (skewness) expectation positively predicts returns on straddle (skewness asset) and generates a profitable option strategy with an annualized Sharpe ratio of 0.93 (1.27). Using the same analyst's expectations for return, variance, and skewness, we uncover a positive subjective risk-return trade-off and a negative skewness-return trade-off that are consistent with classical finance theories. To examine the formation of analyst expectations, we employ large language models to identify key topics from analysts' discussions and apply machine learning techniques to quantify their impacts. Bankruptcy, government debt, and commodities play a crucial role in shaping analysts' variance expectations, while earnings losses, bank loans, and business cycles are the dominant drivers of their skewness expectations. We find strong interaction effects between narratives and option-implied and realized moments in shaping analysts' risk perceptions.
Peer Option Momentum, with Christopher Jones, Mehdi Khorram, Haitao Mo, Lihai Yang, and Yuanyi Zhang
(Supersede an earlier version with Lihai Yang)
We find strong evidence of peer momentum in delta-hedged option returns. Our main peer momentum measure, in which firms are linked if they share common sell-side analysts, is highly profitable, with a pre-cost Sharpe ratio of 2.9. It is distinct from standard momentum, and there is little impact from controlling for standard momentum or other well-know option return predictors. It is robust to the length of the formation periods, the method of return computation, and realistic assumptions about transactions costs. Alternative methods for linking peer firms usually result in weaker performance, though it in most cases remains highly significant. We show that peer momentum is consistent with underreaction of implied volatilities to volatility shocks of peer firms. Using several different approaches, we also show that factor momentum is not a complete explanation of peer momentum. Our final results demonstrate the new finding of peer reversal, which is present in a smaller number of firm pairs but is nevertheless highly significant.
Hedge Fund Option Demand and Crash Risk Premium, with Shuaiyu Chen
(2024 FMA Best Paper Award in Options & Derivatives)
We examine how the option demand of various financial institutions influences the crash risk premium in individual stock options. We find that only the speculative demand of hedge funds exerts a significant impact. Specifically, their demand for put options increases the premium for crash insurance. This effect is concentrated in options with high hedging costs and stems from the long naked put positions of hedge funds. We provide evidence that hedge funds purchase out-of-the-money put options to speculate on the intermediate, not the extreme, left tails of individual firms. They use these options to amplify movements in underlying stock prices, and are willing to pay a premium for the embedded leverage as suggested by Frazzini and Pedersen (2022).
Mutual Fund Hedging Demand and Individual Equity Option Returns