The purpose of this paper is to examine the cross-sectional predictive power and the information content of volatility smirks for future stock returns using single stock options.
The study uses Fama-Macbeth procedure and portfolio approach to investigate the predictability and informativeness in a setup when options settlement style is changed from American to European.
The study reports that the volatility smirk of European style options, unlike American style options, predict the underlying cross-sectional equity returns. Firms with steepest volatility smirk underperform firms with flatter volatility smirks, by an average of 3.28 and 4.01 per cent annually for American and European options, respectively. The results are robust to the control of idiosyncratic and systematic risk factors.
The results confirm that a trader with negative information prefers to trade out-of-the-money put options. The more pronounced results of European options designate the trader’s preference to less risky European style stock options. Results are robust and signify the delay of equity market in incorporating information impounded in the volatility smirk.
Very few studies examine smirk and returns relationship and to the best of the authors’ knowledge, no study exists that examine the unique case of change in options style and its role in affecting relationship between smirk and future returns.
