Market Maker Inventory, Bid–Ask Spreads, and the Computation of Option Implied Risk Measures

Abstract We present empirical evidence showing that option-implied risk measures (OIRMs) are substantially impacted by bid–ask spreads in underlying options. Asking prices are more sensitive to shocks than bids, leading to highly skewed distributions of spreads. We derive and estimate a model of mar...

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Bibliographic Details
Published in:Journal of financial econometrics 2023-11, Vol.21 (5), p.1820-1851
Main Authors: Eraker, Bjørn, Osterrieder, Daniela
Format: Article
Language:English
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Summary:Abstract We present empirical evidence showing that option-implied risk measures (OIRMs) are substantially impacted by bid–ask spreads in underlying options. Asking prices are more sensitive to shocks than bids, leading to highly skewed distributions of spreads. We derive and estimate a model of market making that empirically matches these asymmetric responses as well as the time-series properties of bid–ask spreads. Using these estimates to obtain bias-corrected option quotes, we compute several popular OIRMs. We find that fear and risk premia associated with market events that affect the center of the return distribution or unpredictable return jumps are on average overstated when relying on option mid-quotes, whereas risk associated with return-tail events is larger once the bias has been corrected.
ISSN:1479-8409
1479-8417
DOI:10.1093/jjfinec/nbac025