Reference : Is Risk-Neutral Skewness an Indicator of Jump Risk? Evidence from Tail Risk-Taking of...
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Business & economic sciences : Finance
Is Risk-Neutral Skewness an Indicator of Jump Risk? Evidence from Tail Risk-Taking of Hedge Funds
Lehnert, Thorsten mailto [University of Luxembourg > Faculty of Law, Economics and Finance (FDEF) > Luxembourg School of Finance (LSF) >]
[en] Research suggests that systematic tail risk affects the cross-sectional variation in hedge fund returns. Fund’s tail risk is mainly induced by its investments in more tail-sensitive stocks and is positively related to a trading strategy of writing out-of-the-money put options on the equity market index. Hence, high tail risk hedge funds are exposed to higher moments risks; they sell market volatility risk and buy market skewness risk. The relationship between the return spread of a high minus low tail risk strategy and a market volatility factor is expected to be negative and empirically observed to be negative. However, the relationship between a tail risk strategy and a market skewness factor is expected to be positive but I find it to be negative. In this paper, I explore this puzzling result. Using equity-oriented hedge fund return data, I find that equity market skewness risk explains a major part of variations in hedge funds’ tail risk. My results suggest that the observed negative relationship relates to the problem of price pressure associated with “crowded trades” of mutual funds. Given that retail investors are prone to herding, the directional trading of mutual funds is correlated, and their collective actions can generate short-term price pressure on aggregate stock prices (price ‘noise’). Short sellers systematically exploit these patterns not only in the equity lending market, but also in the options market by moving in the opposite direction. Hence, in times when investors shift their funds from bond to equity mutual funds, short selling in the options market, the non-fundamental demand for index put options, induces a negative relationship between risk-neutral market skewness and returns. Accordingly, the long leg of the tail risk strategy appears to be negatively exposed to market skewness risk, which is in contrast to the usual interpretation of option-implied skewness as an indicator of jump risk. My results are in line with empirical evidence that suggests that the shape of the implied volatility curve is attributable to the demand pressure of specific option series and a limited ability of arbitrageurs to bring prices back into alignment.

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