XXV Edition

1-2 December 2016"

Mutual Funds, Price Pressure and Index Options

Thorsten Lehnert, Luxembourg School of Finance

Daily mutual fund trading activities generate non-fundamental price pressure on aggregate stock prices and, therefore, significant flow-induced return patterns in the short-run. Short sellers systematically exploit these patterns and trade strongly in the opposite direction to these flows. Options markets offer an alternative route of taking directional positions. In this paper, using daily aggregate US equity fund flows, I propose an alternative test of the price pressure hypothesis and empirically investigate flow-induced trading activity in index options. Overall, I find strong empirical evidence for directional trading in index option prices. In line with the temporary price pressure hypothesis, the flow-induced bearish trading activity is price destabilizing and leads to a significant drop in risk-neutral skewness; hence, positive flows induce expectations about future negative returns. This negative relationship is, firstly, caused by inflow-induced price pressure, secondly, associated with the unexpected component (based on same-day flows), but not with the expected component (based on prior days’ trading), and, thirdly, is only present for short-term options.

Area: Asset Pricing and Derivatives

Keywords: Price Pressure, Index Options, Mutual Fund Flows, Short Sellers, Risk-neutral Skewness

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