The Leverage Effect and the Basket-Index Put Spread

Benchmark models which exogenously specify equity dynamics cannot explain the large spread in prices between put options written on individual banks and options written on the bank index during the financial crisis. However, theory requires that asset dynamics be specified exogenously, and that endogenously-determined equity dynamics exhibit a "leverage effect" which increases put prices by fattening the left tail of the distribution. The leverage effect is larger for puts on individual stocks than for puts on the index, thus increasing the basket-index spread. Time-series and cross-sectional variation in the leverage effect explains option prices well.

Bai J., Goldstein R., and Yang F. (2018) The Leverage Effect and the Basket-Index Put Spread. Journal of Financial Economics.