Informed trading under different market conditions and moneyness: Evidence from TXO options

We examine the informational role of options across exercise prices under different market conditions. We analyze the influence of options' leverage effect, and market cycles on the cause–effect relation between stock and options markets based on an emerging options market—the Taiwan stock index options market. When aggregating market data irrespective of market cycles and options moneyness, we find that the equity market leads the options market. However, as we control options' moneyness and market cycles, we find that out-of-the-money options lead the stock market by up to 90 min with more pronounced results in downtrends and periods of political tension. Our findings suggest that the informational role of options is interacted with leverage effect and market conditions.     

Keep on smiling? The pricing of Quanto options when all covariances are stochastic

The paper introduces a model for the joint dynamics of asset prices which can capture both a stochastic correlation between stock returns as well as between stock returns and volatilities (stochastic leverage). By relying on two factors for stochastic volatility, the model allows for stochastic leverage and is thus able to explain time-varying slopes of the smiles. The use of Wishart processes for the covariance matrix of returns enables the model to also capture stochastic correlations between the assets. Our model offers an integrated pricing approach for both Quanto and plain-vanilla options on the stock as well as the foreign exchange rate. We derive semi-closed form solutions for option prices and analyze the impact of state variables. Quanto options offer a significant exposure to the stochastic covariance between stock prices and exchange rates. In contrast to standard models, the smile of stock options, the smile of currency options, and the price differences between Quanto options and plain-vanilla options can change independently of each other.     

Predicting systematic risk: Implications from growth options

In accordance with the well-known financial leverage effect, decreases in stock prices cause an increase in the levered equity beta for a given unlevered beta. However, as growth options are more volatile and have higher risk than assets in place, a price decrease may decrease the unlevered equity beta via an operating leverage effect. This is because price decreases are associated with a proportionately higher loss in growth options than in assets in place. Most of the existing literature focuses on the financial leverage effect: This paper examines both effects. We show, with a simple option pricing model, the opposing effects at work when the firm is a portfolio of assets in place and growth options. Our empirical results show that, contrary to common belief, the operating leverage effect largely dominates the financial leverage effect, even for initially highly levered firms with presumably few growth options. We then link variations in betas to measurable firm characteristics that proxy for the fraction of the firm invested in growth options. We show that these proxies jointly predict a large fraction of future cross-sectional differences in betas. These results have important implications on the predictability of equity betas, hence on empirical asset pricing and on portfolio optimization that controls for systematic risk.     

Trading activity and bid–ask spreads of individual equity options

We empirically examine the impact of trading activities on the liquidity of individual equity options measured by the proportional bid–ask spread. There are three main findings. First, the option return volatility, defined as the option price elasticity times the stock return volatility, has a much higher power in explaining the spread variations than the commonly considered liquidity determinants such as the stock return volatility and option trading volume. Second, after controlling for all the liquidity determinants, we find a maturity-substitution effect due to expiration cycles. When medium-term options (60–90 days maturity) are not available, traders use short-term options as substitutes whose higher volume leads to a smaller bid–ask spread or better liquidity. Third, we also find a moneyness-substitution effect induced by the stock return volatility. When the stock return volatility goes up, trading shifts from in-the-money options to out-of-the-money options, causing the latter’s spread to narrow.     

On the Distribution of CBOE Option Trade Prices Occurring Between Consecutive Stock Trades

This paper examines the volume distribution of option trade prices that occurs when the underlying stock price remains constant. The width of these option trade price bands provides direct evidence on the law of one price and the redundancy of options assumed in many option models. We find that index option bands are narrower than equity option bands. Furthermore, for both equity and index options, puts have narrower bandwidths than calls. In general, option price bandwidth is narrow and can be explained by the minimum price movement allowed by the Chicago Board Options Exchanges (CBOE). This supports the single price law and the redundancy assumption. The existence of bid/ask quotes on the option does not materially affect the above results although it does alter the frequency of multiple option trade prices for a given underlying stock price. We note that over 53% of option trading volume occurs without bid/ask quotes on the CBOE compared to less than 15% a decade ago. Our results suggest that the effective bid/ask spread on options is probably no larger than the minimum price movements allowed by the CBOE. Furthermore, the need for the liquidity services of market makers may be declining if the decline in quoting activity stems from cross trading (i.e. trades not involving market makers).     

Do personal taxes affect capital structure? Evidence from the 2003 tax cut

Because the personal tax treatments of interest and dividend income likely affect the relative cost of debt and equity financing, a sharp change in tax treatment could affect firms' optimal leverage. This paper examines the effect of the 2003 equity income tax cut on firms' debt usage. Because this tax cut affected only individual investors, we can use a difference-in-differences method to identify the effect of personal tax on firms' leverage. Previous research has found that the 2003 tax cut encouraged dividend payouts and reduced the cost of equity, but it provides no link to equilibrium leverage ratios. We estimate that the tax cut causes the affected firms' leverage to decrease by about 5 percentage points. Furthermore, we show that the effects of the tax cut are stronger for firms with lower marginal corporate tax rates and for firms that are not financially constrained, consistent with our theoretical predictions. Overall, we find strong evidence that personal tax is an important determinant of firms' optimal leverage.     

Value creation and pricing in buyouts: Empirical evidence from Europe and North America

Using a unique proprietary data set of 1980 realized and unrealized buyouts completed between 1986 and 2010, we examine entry and exit pricing in buyouts and its influence on private equity (PE) sponsors' returns. We find that besides leverage and operational improvements, EBITDA multiple expansion (i.e. the difference between entry and exit pricing) is a fundamental factor in explaining equity returns and the result of skill rather than pure luck. We also provide evidence that more experienced PE sponsors use more debt to finance a PE transaction and debt is positively related to entry buyout pricing. However, for a transaction with a given leverage level, more experienced PE sponsors are able to negotiate lower prices. In addition, our results show that deals conducted by first time funds which are realized in a later stage of a fund's life cycle are associated with lower exit prices which can be explained by the increased exit pressure for the PE sponsor.     

How Integrated are Credit and Equity Markets? Evidence from Index Options

We study the extent to which credit index (CDX) options are priced consistent with S&P 500 (SPX) equity index options. We derive analytical expressions for CDX and SPX options within a structural credit-risk model with stochastic volatility and jumps using new results for pricing compound options via multivariate affine transform analysis. The model captures many aspects of the joint dynamics of CDX and SPX options. However, it cannot reconcile the relative levels of option prices, suggesting that credit and equity markets are not fully integrated. A strategy of selling CDX volatility yields significantly higher excess returns than selling SPX volatility.     

The Determinants of Implied Volatility: A Test Using LIFFE Option Prices

This paper presents and tests a model of the volatility of individual companies' stocks, using implied volatilities derived from option prices. The data comes from traded options quoted on the London International Financial Futures Exchange. The model relates equity volatilities to corporate earnings announcements, interest-rate volatility and to four determining variables representing leverage, the degree of fixed-rate debt, asset duration and cash flow inflation indexation. The model predicts that equity volatility is positively related to duration and leverage and negatively related to the degree of inflation indexation and the proportion of fixed-rate debt in the capital structure. Empirical results suggest that duration, the proportion of fixed-rate debt, and leverage are significantly related to implied volatility. Regressions using all four determining variables explain approximately 30% of the cross-sectional variation in volatility. Time series tests confirm an expected drop in volatility shortly after the earnings announcement and in most cases a positive relationship between the volatility of the stock and the volatility of interest rates.     

The pricing of leverage products: An empirical investigation of the German market for ‘long’ and ‘short’ stock index certificates

This paper describes the first thorough empirical analysis of the pricing of leverage products in the German retail market. These mainly exchange-traded products with an impressive trading volume are frequently advertised as long and short futures contracts, although they are theoretically equivalent to one-sided barrier options. Issuers’ daily quotes for stock index products are compared to (i) theoretical values derived from the prices of Eurex options and to (ii) boundaries obtained from semi-static superhedging strategies. For the vast majority of products, bid and ask quotes significantly exceed both theoretical values and upper hedging boundaries, thus providing almost risk-free profits for the issuers.     

The subprime asset-backed securities market and the equity prices of large complex financial institutions

In this paper, we investigate the relationship between the subprime asset-backed collateralized debt obligations (CDO) market and Large Complex Financial Institutions (LCFIs). We attempt to account for the dynamics between the ABX index returns and the banks’ equity returns through conditioning our analysis on the historical correlation between the variables. Three key results emerge from the analysis. First, we find a positive correlation between movements of the ABX index and the equity returns for all the LCFIs. Second, the volatility of ABX index returns tend to be transmitted to the volatilities of the equity returns of the financial institutions. Third, ABX prices changes lead equity returns changes of the European-based LCFIs. For the US LCFIs a two-way linkage emerges.     

Endless leverage certificates

An endless leverage certificate (ELC) is a novel retail structured product that gives its holder the right to claim the difference between the value of an underlying security and an interest accruing financing level. An ELC ceases to exist if the underlying breaches a contractual knockout level, if the holder exercises, or if she/he sells it back to the issuer. We use Monte Carlo analysis to value ELCs and find that due to limited liability, a typical ELC written on a typical DAX stock can be worth 0.3% more than its intrinsic value (the difference between the value of the underlying and the financing level). Empirically, we find that in January 2007, the 5129 ELCs issued on the thirty DAX stocks traded at an average premium of 0.67% over the intrinsic value, and that the median bid-ask spread, expressed as a percentage of the underlying, was 0.18%. For covered warrants and options this spread measure was almost twice as high. Finally, we find that upon knockout, investors received on average 3.2% less than the theoretical knockout value, which is consistent with discontinuous trading of the underlying. Overall, our findings suggest that ELCs complete the market for leverage seeking retail investors.     

Can we forecast the implied volatility surface dynamics of equity options? Predictability and economic value tests

We examine whether the dynamics of the implied volatility surface of individual equity options contains exploitable predictability patterns. Predictability in implied volatilities is expected due to the learning behavior of agents in option markets. In particular, we explore the possibility that the dynamics of the implied volatility surface of individual stocks may be associated with movements in the volatility surface of S&P 500 index options. We present evidence of strong predictable features in the cross-section of equity options and of dynamic linkages between the volatility surfaces of equity and S&P 500 index options. Moreover, time-variation in stock option volatility surfaces is best predicted by incorporating information from the dynamics in the surface of S&P 500 options. We analyze the economic value of such dynamic patterns using strategies that trade straddle and delta-hedged portfolios, and find that before transaction costs such strategies produce abnormal risk-adjusted returns.     

Noise, equity prices, and hedging: A new approach

The existence of noise trading in equity markets has possible economic implications for arbitrage, and asset pricing. In terms of pricing, noise trading can lead to excess volatility which has been shown to influence the value of options and futures. Furthermore, option research shows that modeling volatility leads to improved hedging performance. To this end, we derive a general hedging model for equity index futures in the presence of noise trading. Our analysis shows how the level and dynamics of noise trading should influence a hedger's behavior. Finally, we empirically test our model using the NASDAQ-100 index futures and FTSE 100 index futures over the period of January 1998 to May 2003.     

Risk sharing in a financial market with endogenous option prices

This article investigates a financial market in which investors may trade in risk-free bonds, stock and put options written on the stock. In each period, stock and option prices are simultaneously determined by market clearing. While the introduction of put options will decrease the systematic risk in the financial market, it will increase the price of risk. Investors with mean-variance preferences will generally hold portfolios containing the primary asset and the put option and may use the option to increase the risk in their wealth position in exchange for higher returns. Aggregate wealth is unaffected by an option market when there are no spillover effects on stock prices, and it is shown that short selling of options will increase the volatility of individual wealth positions. Investors with erroneous beliefs may on average be better off not trading in put options.     

Do option markets substitute for stock markets? Evidence from trading on anticipated tender offer announcements

Using a sample of cash tender offers occurring between 1993 and 2002, we find evidence that the options market has become the preferred venue for traders attempting to profit on anticipated announcements. Options offer advantages relative to stocks. Traders gain leverage by trading in options and multiple options contracts on an individual stock. The results of our study indicate that a substitution effect does exist. Abnormal volume in the option market replaces abnormal volume in the stock market prior to cash tender offer announcements, and this abnormal option volume precedes abnormal stock volume for targets with or without traded options.     

Risk-taking incentives of executive stock options and the asset substitution problem

Various theoretical models show that managerial compensation schemes can reduce the distortionary effects of financial leverage. There is mixed evidence as to whether highly levered firms offer less stock‐based compensation, a common prediction of such models. Both the theoretical and empirical research, however, have overlooked the leverage provided by executive stock options. In principle, adjusting the exercise prices of executive stock options can mitigate the risk incentive effects of financial leverage. We show that the near‐universal practice of setting option exercise prices near the prevailing stock price at the date of grant effectively undoes most of the effects of financial leverage. In a large cross‐sectional sample of Canadian option‐granting firms, we find evidence that executives' incentives to take equity risk are negatively rather than positively related to the leverage of their employers.     

Risk appetite and option prices: Evidence from the Chinese SSE50 options market

This paper studies the relationship between risk appetite and the shape of the implied volatility function for SSE 50ETF options, and examines whether the effects of risk appetite differ on that of call and put options. We propose a new measure of risk appetite using high-frequency data in the stock market. Empirical results show that risk appetite has a significant impact on the level and slope of the implied volatility function, with significant differences between call and put options. In addition, we also find that risk appetite has an obvious asymmetric impact on option prices under the leverage effect.     

Derivatives traders’ reaction to mispricing in the underlying equity

This article examines trading behavior in the options market conditioned on mispricing in the underlying stock. We investigate the price equilibrium between the observed equity asset and the options-implied synthetic share as well as the relative divergence between the two prices. We find a consistently positive relation between the level of stock mispricing and violations of the upper-boundary condition using derivatives, along with an increase in price divergence. To control for the effect of shorting limitations on mispricing, we further examine prices during the short-sale ban in 2008. The results hold and in many instances are more significant during the ban period. Given the persistent disequilibria between the synthetic and observed stock prices, we argue the results are evidence of informed trading in the derivatives market.     

Equity market timing and capital structure: International evidence

We investigate the equity market timing hypothesis of capital structure in major industrialized (G-7) countries. As claimed by its proponents, we find that leverage of firms is negatively related to the historical market-to-book ratio in all G-7 countries. However, this negative relationship cannot be attributed to equity market timing. We find no association between equity issues and market-to-book ratios at the time of equity financing decisions by Japanese firms. Firms in all G-7 countries, except Japan, undo the effect of equity issuance and the impact of equity market timing attempts on leverage is short lived. This is inconsistent with the prediction of the equity market timing hypothesis and more in line with dynamic trade-off model.