The Predictive Power of S&P 500 Option Prices and the Stock Market Crash of 2008-2009

Abstract

Option market prices have often been regarded as a window on investor sentiment about the future price behaviour of the underlying asset. Such market prices can be different than their corresponding model prices, a phenomenon revealed by implied volatility plots exhibiting “smiles” or “smirks”. Using the unique capabilities of Bayesian-based empirical methods, a four-moment risk-neutral specification is determined that largely eliminates market and model price differences. The risk-neutral density derived for a sample of S&P 500 call option prices during 2008-2009 uncovers significant market under-pricing reinforced by anomalous volatility skews that reveal bearish investor sentiment clearly signalling the pending equity market collapse