Lottery and bubble stocks and the cross-section of option-implied tail risks

Abstract

The options smile provides forwardlooking information about the risk at thecenter of the distribution (ATMIV) and at the tails (Skew). We investigate thecrosssectional determinants of the options smile using indices that capturefirm fundamental risks, heterogeneity in belief, lottery characteristics, andbubble characteristics. We find that atthemoney (ATM) volatility is explainedmainly by historical risks and predicted future risks measured usingaccountingbased risk measures and firm characteristics. However, the crosssectional variation in the skew is driven by risk premia and by buying andselling pressure, which is influenced by heterogeneity in belief and the un-derlying's lotterylike and bubblelike characteristics.