The Driving Forces Behind Higher Moments in Equity Options Trading

The Driving Forces Behind Higher Moments in Equity Options Trading

• Pascal Letourneau, University of Wisconsin-Whitewater

Abstract:

In this paper, we investigate the determinant factors that drive the higher moments of the implied risk-neutral density for firms. Specifically, we study whether the firms’ financial ratios impact kurtosis, which is an important moment to consider when using options as an investment vehicle or market making. We use a parsimonious model of the implied volatility surface (IVS hereafter) and random forest regressions to study the impact of these factors in a forecasting exercise. We also test the economic significance by back-testing a trading strategy on options. Our contribution to the literature is being one of the very few papers to tackle the prediction of the IVS while including external factors. Our results show that firm’s financial ratios do influence the risk-neutral kurtosis, but the effect is circumstantial. We confirm a spillover of market risk at time t to firm risk at time t+1. Overall, our findings provide valuable insights into the factors that drive the higher moments of the implied risk-neutral density for firms, which can help investors make better investment decisions regarding options.

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