Skewness Term Structure Tests

In this paper, we conduct skewness term structure tests to check whether the temporal structure of risk-neutral skewness is consistent with rational expectations. Because risk-neutral skewness is substantially mean reverting, skewness shocks should decay quickly and risk-neutral skewness of more distant option should display the rationally expected smoothing behavior. Using an equilibrium asset and option-pricing model in a production economy under jump diffusion with stochastic jump intensity, we derive this elasticity analytically. In an empirical application of the model using more than 20 years of data on S&P500 index options, we find that this elasticity turns out to be different than suggested under rational expectations - smaller on the short end (undereaction) and larger on the long end (overreaction) of the ‘skewness curve’.