Skewness and the Bubble

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Abstract
We use a sample of option prices, and the method of Bakshi, Kapadia and Madan (2003), to estimate the ex ante higher moments of the underlying individual securities' returns distribution. We find that individual securities' volatility, skewness and kurtosis are strongly related to returns, even after controlling for differences in size and book-to-market. Consistent with Ang, Hodrick, Xing and Zhang (2006), we find a negative relation between cross-sectional volatility and returns. We also find a significant relation between skewness and returns, with more negatively (positively) skewed returns associated with subsequent higher (lower) returns. We find that adding payoffs related to individual securities' skewness changes investors' opportunity sets, as measured by Hansen-Jagannathan bounds and tests of spanning. We use data on index options and the underlying market return to estimate the pricing kernel over the 1996-2005 sample period and examine the time-variation in risk-neutral and implied physical distributions of individual securities.

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