Investor expectations and the covid-19 stock market crash. What can we learn from index options? : a replicating study of David Bates’ The Crash of ’87 : was it expected? : the evidence from options markets.

Abstract

We investigate the transaction prices of SPX options on the S&P 500 Composite Index over the years 2018 to 2020, to examine whether there can be shown evidence of expectations of a market crash before February 20, 2020. This is done by replicating the methods used in David Bates’ “The Crash of ’87: Was it Expected? The Evidence from Options Markets”. First, we show that out-of-the-money put options were trading at a premium relative to out-of-themoney call options during most of the period examined. In the beginning of the crisis this premium decreased, and it was not until March 16, 2020, that the market participants began to buy protection. Second, we estimate jump-parameters implicit in SPX option prices based on Bates’ model of option pricing under an asymmetric jump-diffusion. The results indicate that there was no unnormal expectancy of jumps before the crash occurred in February. We find no evidence of a reaction in market expectations until mid-March. The same is true for the calculated implied volatility, skewness and kurtosis of the underlying return distribution. Hence, we conclude that both methods find no evidence of increased crash fears prior to the market crash beginning on February 20, 2020. We find that the full impact of the crisis is not observed in market expectations elicited from SPX option prices until March 2020.