Skewness Risk Premium in the Options Market

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Skewness of returns is a statistical measure that captures the asymmetry of the distribution of an asset’s returns over a specified period. It is particularly important in risk management and option pricing, where the skewness of returns can affect the valuation of derivatives and the construction of portfolios.

Reference [1] studies the skewness risk premium in the options market. It decomposes the skewness risk premium into two components: jump skewness and leverage skewness risk premia. The authors pointed out,

We introduce novel distinguishing notions of realized skewness that can be replicated with model-free trading strategies. They admit a decomposition into a tradable jump skewness component and a tradable leverage effect component. Our replicating strategies dynamically rebalance option and forward positions with a common expiration date to produce settlement payoffs matching high-frequency realized jump skewness and realized leverage over horizons that may not coincide with the underlying forward and option maturities. When markets are open, this feature allows us to identify daytime jump and leverage components of the skewness risk premium. Furthermore, it allows us to separate them from the skewness risk premium earned overnight.

We analyze the properties of the excess returns of our skewness strategies in the market for short maturity S&P500 options, both intraday and overnight, to learn more about the size of the market skewness risk premium, its seasonal variation when markets are open or closed, and its cyclicality. We find that the skewness risk premium is large, greater when markets are closed than when they are open, countercyclical, and distinct from the variance risk premium. During market open hours, when the jump and leverage skewness components can be traded separately with our approach, we also find that the skewness risk premium is dominated by priced jump skewness risk.

In short, the authors constructed a tradable basket of options to measure the skewness risk premium. This means that this study is model-free.

They reconfirmed that

• The skewness risk premium is different from the variance risk premium.
• The variance risk premium is compensation for bearing overnight risks.

Additionally, they pointed out,

• Like the variance risk premium, the overnight skewness risk premium is higher than the daytime skewness risk premium
• The daytime skewness risk premium consists mostly of the jump skewness risk premium.

Let us know what you think in the comments below or in the discussion forum.

References

[1] Piotr Orłowski , Paul Schneider , Fabio Trojani, On the Nature of (Jump) Skewness Risk Premia, Management Science, Vol 70, No 2

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