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 Skewness Risk Premium, with Shuaiyu Chen
(2024 FMA Best Paper Award in Options & Derivatives)
We examine how hedge fund option demand influences the skewness risk premium. Fund demand for put options positively predicts cross-sectional returns of skewness assets constructed from individual stock options. This return predictability concentrates on options with high hedging costs and stems from long naked put positions but not protective puts or straddles. We provide evidence that hedge fund speculative demand for firm-specific downside risk creates demand pressure on out-of-the-money put options, resulting in lower prices and higher future returns for skewness assets. Long naked put positions do not predict realized skewness, and are associated with fund underperformance during COVID-19.
Mutual Fund Hedging Demand and Individual Equity Option Returns