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Accounting for Earnings Announcements in the Pricing of Equity Options

Journal of Financial Engineering, vol. 1, no.4, pp.1-46, 2014

36 Pages Posted: 5 Jul 2014 Last revised: 8 Apr 2015

Tim Leung

University of Washington - Department of Applied Math

Marco Santoli

Columbia University

Date Written: April 7, 2015

Abstract

We study an option pricing framework that accounts for the price impact of an earnings announcement (EA), and analyze the behavior of the implied volatility surface prior to the event. On each known announcement date, we introduce a random jump to the stock price. Applying this idea to extend the Black-Scholes model, we obtain formulas for the pre-EA European option price, its implied volatility and various Greeks. We further incorporate random-time jumps in the stock price by extending the Kou jump-diffusion model to incorporate an EA jump, and provide an analytic option pricing formula. Moreover, we derive analytic bounds and asymptotics for the pre-EA implied volatility under various models. The calibration results demonstrate adequate fit of the entire IV surface prior to an announcement. We also compare the risk-neutral distribution of the EA jump to its historical distribution. Finally, we discuss the valuation and exercise strategy of pre-EA American options, and illustrate an analytical approximation and numerical results.

Keywords: earnings announcement, equity options, pre-earnings announcement implied volatility

JEL Classification: G12, G13, G14

Suggested Citation

Leung, Tim and Santoli, Marco, Accounting for Earnings Announcements in the Pricing of Equity Options (April 7, 2015). Journal of Financial Engineering, vol. 1, no.4, pp.1-46, 2014 . Available at SSRN: https://ssrn.com/abstract=2462298

Tim Leung

University of Washington - Department of Applied Math ( email )

Lewis Hall 217
Department of Applied Math
Seattle, WA 98195
United States
9253381749 (Phone)

HOME PAGE: http://faculty.washington.edu/timleung/

Marco Santoli (Contact Author)

Columbia University ( email )

321 S.W. Mudd Building
500 West 120th Street
New York, NY 10027
United States

HOME PAGE: http://www.marcosantoli.com

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