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RFS Advance Access originally published online on November 20, 2007
Review of Financial Studies 2008 21(1):387-414; doi:10.1093/rfs/hhm071
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© The Author 2007. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org

Investor Sentiment and Option Prices

Bing Han
McCombs School of Business, University of Texas at Austin

Address correspondence to Bing Han, McCombs School of Business, 1 University Station, B6600, University of Texas at Austin, Austin, TX 78712; telephone: 512-232-6822; email: bhan{at}mail.utexas.edu.

JEL Classification: G12, G13, G14


  Abstract

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.

I am grateful to Gregory Brown and Michael Cliff for providing the data on investor sentiment, and to Steven Sharpe for sharing his calculation of the valuation errors for the S&P 500 Index. I thank Editor Yacine Ait-Sahalia, two anonymous referees, Nai-fu Chen, David Hirshleifer, Neil Pearson, Allen Poteshman, Hersh Shefrin, and Rene Stulz for invaluable discussions, and seminar participants at Brigham Young University, Ohio State University, University of California at Irvine, and American Finance Association 2006 Meetings for comments on earlier drafts. All remaining errors are my own.


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