Accounting Transparency and the Implied Volatility Skew

Abstract

Stock price jump risk is known to be important for explaining the option-implied volatility skew generated by the Black-Scholes model. Financial leverage (distress) has an important impact on the shape of the implied volatility skew, however, we find that the impact of leverage on the implied volatility skew depends on the quality of the firm’s accounting transparency. In this paper, we propose a model where incomplete accounting information and the risk of financial distress together act as important drivers of jump rates and sizes for individual stocks. Consistent with our model, empirical tests using individual stock option data indicate that the impact of leverage on the skew is weaker for firms with lower accounting transparency and stronger for firms with higher accounting transparency.

Keywords: Implied Volatility Skew, Accounting Transparency, Credit Risk

JEL Classification: G12, G13