1. 1 Joshua Livnat Department of Accounting Stern School of Business Administration New York University 311 Tisch Hall 40 W. 4th St. New York City, NY 10012 (212) 998–0022 jlivnat@stern.nyu.edu

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3. 3 Overview - Continued We estimate the average option implied volatility skews (skews) in three periods around earnings announcements and other disclosures about companies: Base, days [-50,-11] Pre, days [-10,-2] Post, days [+1,+5] We assess the association of skews with excess returns around the announcement [-1,+1], and with the subsequent drift [+2,+90] or [+6,+90].

4. 4 Overview - Continued We find evidence of both information leakage and superior ability to process information. The Pre skews are negatively correlated with announcement period returns -- leakage. The Post skews are negatively associated with drift returns during [+6,+90] when the uncertainty about the future remains high -- superior ability to process public information.

5. 5 Contributions Better understanding of the interactions between the option and stock markets. Why are option prices leading stock prices? Useful for stock investors. Potentially useful for regulators – cases of information leakage.

6. 6 Data Acknowledgements Charter Oak Investment Systems Inc. for providing the preliminary and original Compustat quarterly data. http://www.charteroaksystems.com/ Capital IQ for Key Developments data.

7. 7 Implied Volatility Skew Identify all call and put options with a maturity in the window [+10, +60] and open interest>0. Examine all call options with delta in the range of [0.4,0.7], and choose the one closest to delta of 0.5. This is the At-The-Money call. Examine all put options with delta in the range of [-0.15,-0.45], and choose the one closest to delta of -0.3. This is the Out-Of-The-Money put. Skew = Imp. Vol. Put - Imp. Vol. Call .

8. Implied Volatility Skew - Intuition When market participants expect a future negative event they will hedge by holding out-of-the-money puts. Demand for these puts will increase, raising their prices, and increasing the implied volatility of the out-of-the-money puts. 8

9. 9 Literature The closest study is Xing et al (JFQA, 2008). They use the skew to predict future abnormal returns. They show that the skew is negatively correlated with abnormal stock returns in the following week. They show that the skew is positively associated with negative earnings news during the subsequent quarter. Van Buskirk (2009) uses the skew to predict the probability of large future stock price declines. Skew predicts earnings announcement return declines, as well as subsequent drift. Skew does not predict declines around management forecast or dividend announcements.

10. 10 Research Question Assuming option skews can predict future returns, what can be the reason? Option traders possess private information. Anecdotal evidence that people with private information about M&A trade options due to their leverage. Anecdotal evidence about out of the money puts prior to the Lehman Brothers demise. Option traders are more focused on tail events because they have to price puts. Better able to assess the magnitude, timing and likelihood of tail events.

11. Research Design Unlike Xing et al. (2008), we focus on the skew just prior to an announcement, and compare its association with announcement stock returns to a more dated skew. We focus on the skew after an announcement and its ability to predict future stock returns. We use both scheduled earnings announcements and unscheduled other disclosures. 11

12. Timeline 12

13. Expectations Both Base and Pre skews will be negatively associated with the announcement returns and drift1. If there is information leakage, Pre skew will be more strongly associated with announcement returns than Base skew. If there is information uncertainty and option traders are better at quantifying it, Post skew will be negatively associated with Drift2. 13

14. 14 Data Optionmetrics 1996-2009. Implied volatilities, duration and open interest. Compustat preliminary data. Earnings announcement dates and accruals disclosed in the preliminary earnings release. IBES Detail. Earnings surprises (actual and expected quarterly earnings). CRSP. Abnormal returns. Key Developments. Dates of other announcements. 2002 onwards.

15. Mean Volatility Skew - Earnings 15

16. Predicting Earnings Surprises 16

17. Predicting Returns around Earnings Announcements 17

18. Predicting Drift Returns 18

19. Predicting Drift with SKEWPOST 19

20. Predicting Drift –By Earnings Surprise 20

21. Key Development Data 21

22. Predicting Announcement Returns 22

23. Predicting Drift Returns 23

24. Predicting Drift – By Event Returns 24

25. 25 Takeaways The evidence suggests that there is information leakage to option market prior to the stock market. The evidence is also consistent with option traders’ superior ability to assess tail risk events.