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COPYRIGHT 2007 International Academy of Business and Economics
ABSTRACT
This study explores the nature of pre-event investor sentiments based on anomalies in implied options and intraday volatilities. Implied volatility is known to convey investor sentiments by its tendency to rise in advance of a market downturn. Because the airline industry was particularly distressed by the 2001 terror attacks in the United States, the magnitude of its pre-event volatility patterns is measured against that of the rest of the market. Empirical results show that pre-event abnormal returns for airlines is negative and is, in general, larger than that of the market as a whole. There was also a remarkable increase in pre-event implied volatility, which provided short position holders with profitable trading opportunities. In the price-risk relationship, Granger causality results are mixed, showing in particular that a bi-directional causality exists between implied volatility and equity market valuation.
Keywords: Implied Options Volatility, Intraday Volatility, Pre-event Abnormal Returns, Granger Causality.
1. INTRODUCTION
This study examines the ability of implied options volatility to predict near-term market anomalies using the 9-11 incident as a backdrop. Intraday volatility is also examined as a means to capture prevailing market sentiments. By evaluating market behavior with both implied and intraday volatilities, a composite picture of investor anxiety is captured especially in pre-event time. Empirical results show that the magnitude of pre-event cumulative abnormal return for the airline stocks is statistically significantly larger than that of the market as a whole. Also, there was a remarkable rise in implied volatility just before the incident, as evidenced by a significant positive abnormal trend.
Implied options volatility conveys the expectation of the rate and magnitude of future price changes of the underlying asset, not the derivative contract. Every so often, there is a discrepancy between the theoretical price of an option and its market value. Summa (2002) explains that this deviation is due to the amount of expected or implied volatility (IV) which the market prices into the option. Thus, a high IV suggests that the option's market price is greater than its theoretical price. A rising IV reflects the growing uncertainty that the market imputes in the price of the derivative. In the circumstance, a high volatility indicates that the sale of options, rather than their purchase, is a more attractive strategy.
Volatilities, in general, convey the essence of risk in the market. Three notable volatility metrics are the historical close-to-close variance, intra-day volatility, and implied volatility. Implied volatility, derived from option prices, is used to gauge investor sentiments about future market disturbances. In 1993, the Chicago Board Options and Exchange (CBOE) began the construction of an implied volatility index, called the VIX. Since then, this index has remained a popular indicator of near-term market anomaly. Corrado and Miller (2005) investigate the ability of the VIX to predict market events, whereas Whaley (2000) show how traders use up-to-the-minute estimates of expected volatility to gauge investor fear. In addition, Corrado and Miller (2006) show that a positive relation exists between expected and realized excess returns when risk is measured using implied option volatility, rather than historical volatility.
2. LITERATURE
The use of volatility metrics to evaluate market performance and investor risk is not new in the literature. Earlier studies were based on range-based estimators of investment risk. Parkinson (1980) first considered this problem under the assumption that securities follow a continuous Brownian motion. Using a distribution first derived by Feller (1951), he finds a variance estimator for a security whose natural log follows a...
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