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Pricing Event Risk: Evidence from Concave Implied Volatility Curves

Author

Listed:
  • Lykourgos Alexiou

    (Athens University of Economics and Business)

  • Amit Goyal

    (University of Lausanne; Swiss Finance Institute)

  • Alexandros Kostakis

    (University of Liverpool Management School; University of Manchester - Manchester Business School)

  • Leonidas Rompolis

    (Athens University of Economics and Business - Department of Accounting and Finance)

Abstract

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.

Suggested Citation

  • Lykourgos Alexiou & Amit Goyal & Alexandros Kostakis & Leonidas Rompolis, 2021. "Pricing Event Risk: Evidence from Concave Implied Volatility Curves," Swiss Finance Institute Research Paper Series 21-48, Swiss Finance Institute.
    • Handle: RePEc:chf:rpseri:rp2148
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    Cited by:

    1. Darsh Kachhara & John K. E Markin & Astha Singh, 2023. "Option Smile Volatility and Implied Probabilities: Implications of Concavity in IV Curves," Papers 2307.15718, arXiv.org, revised Nov 2023.
    2. Pascal François & Rémi Galarneau‐Vincent & Geneviève Gauthier & Frédéric Godin, 2022. "Venturing into uncharted territory: An extensible implied volatility surface model," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 42(10), pages 1912-1940, October.

    More about this item

    Keywords

    Earnings Announcement; Event Risk; Risk-Neutral Distribution; Implied Volatility Curve;
    All these keywords.

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