Pricing Event Risk: Evidence from Concave Implied Volatility Curves
45 Pages Posted: 7 May 2021
Date Written: April 20, 2021
We document that implied volatility (IV) curves extracted from short-term equity options frequently become concave prior to the earnings announcement day (EAD) reflecting a bimodal risk-neutral distribution for the underlying stock price. Firms with concave IV curves exhibit significantly higher absolute stock returns on EAD and higher realized volatility after the announcement, as compared to firms with non-concave IV curves. Hence, concavity in the IV curve constitutes an ex-ante option-based signal for event risk in the underlying stock. Returns on delta-neutral straddles around EADs are significantly lower in the presence of concave IV curves, showing that investors pay a high premium to hedge against this event risk.
Keywords: Earnings Announcement, Event Risk, Risk-Neutral Distribution, Implied Volatility Curve
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