Opacity, Crash Risk, and the Option Smirk Curve
41 Pages Posted: 17 Jul 2010 Last revised: 9 Aug 2010
Date Written: July 15, 2010
We investigate three facets of cross-sectional variation in the risk of stock price crashes: actual crash incidence, and two predictors of that risk, accounting opacity and the option smirk curve. We show that all three of these variables are related. Option smirks and accounting opacity each independently predict cross-sectional variation in crash risk and crash magnitude. The slope of the smirk curve and opacity are themselves correlated at extremely high levels of statistical significance, indicating that the market is aware of the link between opacity and crash risk. Nevertheless, even controlling for the option smirk, several measures of accounting opacity continue to be reliably associated with crash risk, suggesting that the options market does not fully utilize the predictive value of accounting opacity. Moreover, some of our results are consistent with behavioral models in which strong recent performance is extrapolated too far into the future, only to result in a major reversal when those expectations are disappointed.
Keywords: option pricing, earnings management, crash risk, transparency, opacity, smirk
JEL Classification: G19, D89, M40
Suggested Citation: Suggested Citation