Abstract
We exploit information in option prices in order to study whether the ex post responsiveness of stock prices to earnings information is reflected from an ex ante, firm- and quarter-specific perspective. Specifically, we develop a measure of anticipated information content (AIC) that isolates the forecasted magnitude of the stock market’s reaction to earnings information. We find that the AIC positively correlates with the ex post magnitude of the stock market sensitivity to unexpected earnings, increases with earnings persistence, firm growth prospects, the richness of firms’ information environments and the presence of (and changes in) sophisticated ownership, and decreases with discount rates. Our paper sheds light on the role that earnings information plays in sha** option-market behavior and offers researchers an option-market approach to studying the responsiveness of stock prices to earnings information.
This is a preview of subscription content, log in via an institution to check access.
Similar content being viewed by others
Notes
For example, consider an option with a $50 strike price that expires in 2 days. If the firm’s current stock price is $50 and its normal annual volatility is 25% (1.58% per day, assuming identically and independently distributed returns across 250 trading days per year), then the theoretical Black–Scholes (1973) option value equals 36 or 37 cents using a 4% annual risk-free interest rate. Suppose that the market anticipates an earnings release the day before the option expires and that the market believes that the impending announcement will cause a three-standard-deviation movement in the stock price. If investors consider the influence of this impending earnings news on the firm’s stock price, the market prices the option to incorporate the three-sigma stock price movement. Thus, in this case, the option sells for around $2.37 (= $50 * 0.0158 * 3). Other options might exist for this stock. In this scenario, despite the impending earnings, a call option with a $55 strike price remains virtually worthless because the three-sigma movement fails to make the option valuable at expiration. Alternatively, a call option with a strike price of $45 has a trading value of approximately $7.37. This price includes $5 due to the current stock price relative to the strike (i.e., the option is $5 in the money) and $2.37 of potential upside associated with the volatility from the impending earnings release.
For example, researchers might exploit the AIC’s firm- and quarter-specificity to investigate whether idiosyncratic disclosures that reflect the quality of a firm’s financial reporting affect investors’ anticipation of the strength of the return-earnings relation. Following prior literature that uses the traditional ERC as a proxy for earnings quality (Teoh and Wong 1993; Moreland 1995; Hackenbrack and Hogan 2002; Balsam et al. 2003), one might expect changes in the reliability of financial statements (as measured by high abnormal accruals, a restatement, or a material weakness disclosure) to be associated with decreases in firm- and quarter-specific AICs at the time the event occurs. Indeed, the frequent availability of the AIC affords researchers the opportunity to study the influence of any event on the magnitude of the return-earnings relation on a timely basis.
Earnings releases can and usually do include information above and beyond information about the firms’ current earnings. For this additional information to influence the AIC, it must be (1) information that option traders can anticipate (i.e., option traders can forecast both content and timing), (2) information that is value-relevant and (3) information to which option traders cannot assign a direction to the underlying stock price movement. Given these requirements, we expect that the additional information captured by the AIC that is not captured by traditional ERCs largely pertains to future earnings streams.
Unless we anticipate asymmetric stock price responses for positive or negative earnings surprises (perhaps due to accounting policies), the potential earnings information equally affects puts and calls. Limiting analysis to one option per firm-quarter (which addresses, among other issues, concerns regarding dependence of error terms) reduces the sample size by about 50%, but conclusions do not change. Similarly, conclusions do not change if we limit analysis to either puts or calls.
Using unadjusted (for stock splits) analyst forecasts (Payne and Thomas 2003) does not change our conclusions.
Bagnoli et al. (2002) provide evidence that the vast majority of earnings announcements occur on the date expected. Accordingly, assuming that the EA_DATE is known (1 day before) is not unreasonable. Because of the firm-specific nature of earnings announcements, the length of the series of data leading up to and following the EA_DATE varies. If the EX_DATE falls on the EA_DATE, the series of data ends when the option expires and we remove the observation from the sample. In other words, we do not include any options that expire on or before the EA_DATE. Conclusions are unchanged if we limit our sample to observations having 17 (the median) or fewer calendar days between the EX_DATE and the EA_DATE.
Our sample selection criteria and our definition of moneyness inevitably allow some slightly OTM and ITM options into our final sample of option prices. Although we anticipate that this introduces noise (not bias) in our tests, we also explore more restrictive definitions of ATM. In particular, limiting our analysis to observations where the strike price falls within 1% (as opposed to 5%) of the current stock price reduces the sample by approximately 75%, but all of our findings and associated conclusions do not change. We discuss an alternative approach to addressing the noise introduced by the inclusion of slightly OTM and ITM options (i.e., the inclusion of a control variable representing the dollar moneyness of the option on the right side of each regression) in the next section.
Consistent with our concerns regarding the comparability of a firm- and quarter-specific measure and a coefficient estimate obtained via a pooled regression, Teets and Wasley (1996) find that firm-specific ERCs, on average, differ substantially from those obtained from regressions that pool observations across both firms and time.
As his analysis requires only financial statement and stock return data, Atiase (1985)’s large and small firms differ substantially (i.e., his large firms are at least 20 times larger than his small firms).
In addition, other ERC studies indicate that this relation may not manifest. For example, although Collins and Kothari (1989) find that the strength of the return-earnings relation varies with firm size, they show that the relation loses significance after other controls for differences in the information environment are considered.
In the next section, we provide evidence that our variables of interest exhibit differences across the sub-periods.
Please refer to the appendix for a complete list of the variables we use in this analysis.
As mentioned earlier, in untabulated sensitivity tests, we also explore more restrictive definitions of ATM. In particular, limiting our analysis to observations where the strike price falls within 1% (as opposed to 5%) of the current stock price reduces the sample by approximately 75%, but all of our findings and associated conclusions do not change.
The firm’s β is assessed annually and the firm’s persistence parameter is estimated over the entire eleven-year sample period.
References
Amin, K., & Lee, C. (1997). Option trading and earnings news dissemination. Contemporary Accounting Research, 14, 153–192.
Atiase, R. (1985). Predisclosure information, firm capitalization, and security price behavior around earnings announcements. Journal of Accounting Research, 21–36.
Bagnoli, M., Kross, W., & Watts, S. (2002). The information in management’s expected earnings report data: A day late, a penny short. Journal of Accounting Research, 1275–1296.
Ball, R., & Brown, P. (1968). An empirical evaluation of accounting income numbers. Journal of Accounting Research, 6, 159–178.
Balsam, S., Krishnan, J., & Yang, J. S. (2003). Auditor industry specialization and earnings quality. Auditing: A Journal of Practice and Theory, 22(2), 71–97.
Barron, O., Kim, O., Lim, S., & Stevens, D. (1998). Using analysts’ forecasts to measure properties of analysts’ information environment. The Accounting Review, 73, 421–433.
Beaver, B. (1968). The information content of annual earnings announcements. Journal of Accounting Research, 67–92.
Beaver, W., Clarke, R., & Wright, W. (1979). The association between unsystematic security returns and the magnitude of earnings forecast errors. Journal of Accounting Research, 17, 316–340.
Beaver, W., Lambert, R., & Morse, D. (1980). The information content of security prices. Journal of Accounting and Economics, 2, 3–28.
Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81, 637–654.
Bushee, B. (2001). Do institutional investors prefer near-term earnings over long-run value? Contemporary Accounting Research, 18, 207–246.
Bushee, B., & Noe, C. (2000). Corporate disclosure practices, institutional investors, and stock return volatility. Journal of Accounting Research, 171–202.
Collins, D., & Kothari, S. P. (1989). An analysis of intertemporal and cross-sectional determinants of the earnings response coefficient. Journal of Accounting and Economics, 11, 143–181.
Collins, D., Kothari, S. P., & Rayburn, J. (1987). Firm size and the information content of prices with respect to earnings. Journal of Accounting and Economics, 9, 111–138.
Cremers, M., & Weinbaum, D. (2010). Deviations from put call parity and stock return predictability. Journal of Financial and Quantitative Analysis, 45, 335–367.
Demers, E., & Lev, B. (2001). A rude awakening: Internet shakeout in 2000. Review of Accounting Studies, 6, 331–349.
Donders, M., Kouwenberg, R., & Vorst, T. (2000). Options and earnings announcements: An empirical study of volatility, trading volume, open interest and liquidity. European Financial Management, 6, 149–171.
Easton, P., & Zmijewski, M. (1989). Cross-sectional variation in the stock market response to accounting earnings announcements. Journal of Accounting and Economics, 11, 117–141.
Fleming, J., Ostdiek, B., & Whaley, R. (1996). Trading costs and the relative rates of price discovery in stock, futures, and option markets. Journal of Futures Markets, 16, 353–387.
Hackenbrack, K., & Hogan, C. (2002). Market response to earnings surprises conditional on reasons for an auditor change. Contemporary Accounting Research, 19, 195–223.
Hand, J. (2001). The role of book incomes, web traffic, and supply and demand in the pricing of US internet stocks. European Finance Review, 5, 295–317.
Imhoff, E., & Lobo, G. (1992). The effect of ex ante earnings uncertainty on earnings response coefficients. The Accounting Review, 67, 427–439.
Kim, J., Krinsky, I., & Lee, J. (1997). Institutional holdings and trading volume reactions to quarterly earnings announcements. Journal of Accounting, Auditing and Finance, 12, 1–14.
Kormendi, R., & Lipe, R. (1987). Earnings innovations, earnings persistence, and stock returns. Journal of Business, 60, 323–345.
Kothari, S. P. (2001). Capital markets research in accounting. Journal of Accounting and Economics, 31, 105–231.
Kothari, S. P., & Sloan, R. (1992). Information in prices about future earnings: Implications for earnings response coefficients. Journal of Accounting and Economics, 14, 143–171.
Manaster, S., & Rendleman, R. (1982). Option prices as predictors of equilibrium stock prices. Journal of Finance, 37, 1043–1057.
May, R. G. (1971). The influence of quarterly earnings announcements on investor decisions as reflected in common stock price changes. Journal of Accounting Research, 9, 119–163.
Mayhew, S., & Mihov, V. (2004). How do exchanges select stocks for option listing. Journal of Finance, 59, 447–471.
Moreland, K. (1995). Criticisms of auditors and the association between earnings and returns of client firms. Auditing: A Journal of Practice and Theory, 14(Spring), 94–104.
Ni, S., Pan, J., & Poteshman, A. (2008). Volatility information trading in the option market. Journal of Finance, 63, 1092–1959.
Patell, J., & Wolfson, M. (1979). Anticipated information releases reflected in call option prices. Journal of Accounting and Economics, 1, 117–140.
Patell, J., & Wolfson, M. (1981). The ex ante and ex post price effects of quarterly earnings announcements reflected in option and stock prices. Journal of Accounting Research, 19, 434–458.
Payne, J., & Thomas, W. (2003). The implications of using stock-split adjusted I/B/E/S data in empirical research. The Accounting Review, 78, 1049–1067.
Potter, G. (1992). Accounting earnings announcements, institutional investor concentration and common stock returns. Journal of Accounting Research, 30, 146–155.
Roll, R., Schwartz, E., & Subrahmanyam, A. (2010). O/S: the relative trading activity in options and stocks. Journal of Financial Economics, 91, 1–17.
Schmalensee, R., & Trippi, R. (1978). Common stock volatility expectations implied by option premia. Journal of Finance, 33, 129–147.
Skinner, D. (1990). Options markets and the information content of accounting earnings releases. Journal of Accounting and Economics, 13, 191–211.
Teets, W., & Wasley, C. (1996). Estimating earnings response coefficients: Pooled versus firm-specific models. Journal of Accounting and Economics, 21, 279–295.
Teoh, S., & Wong, T. (1993). Perceived auditor quality and the earnings response coefficient. The Accounting Review, 68(April), 346–366.
Trueman, B., Wong, F., & Zhang, X. (2000). The eyeballs have it: Searching for the value in internet stocks. Journal of Accounting Research, 38, 137–162.
Trueman, B., Wong, F., & Zhang, X. (2003). Anomalous stock returns around Internet firms’ earnings announcements. Journal of Accounting and Economics, 34, 249–271.
**ng, Y., Zhang, X., & Zhao, R. (2009). “What does individual option volatility smirk tell us about future equity returns?” forthcoming. Journal of Financial and Quantitative Analysis.
Xu, B., Magnan, M., & Andre, P. (2007). The stock market valuation of R&D information in biotech firms. Contemporary Accounting Research, 24, 1291–1318.
Acknowledgments
This paper benefited from the insightful comments of Peter Easton (the editor), Jeff Burks (the discussant), two anonymous referees, Eli Bartov, Daniel Beneish, Brian Cadman, Gavin Cassar, Melissa Lewis, Alexander Nezlobin, Jim Ohlson, Christine Petrovits, Stephen Ryan, Jerry Salamon, Wayne Thomas, Andrey Ukhov, Jim Wahlen, workshop participants at Indiana University, Rutgers University, and the University of Utah, and participants at the 2009 New York University Summer Camp, the 2010 Columbia-NYU Workshop, and the 2010 Review of Accounting Studies Conference. We thank Brian Bushee for supplying institutional ownership classification coding.
Author information
Authors and Affiliations
Corresponding author
Appendix
Rights and permissions
About this article
Cite this article
Billings, M.B., Jennings, R. The option market’s anticipation of information content in earnings announcements. Rev Account Stud 16, 587–619 (2011). https://doi.org/10.1007/s11142-011-9156-5
Published:
Issue Date:
DOI: https://doi.org/10.1007/s11142-011-9156-5
Keywords
- Information content of earnings announcements
- Options
- Volatility
- Institutional ownership
- Information environment
- Return-earnings relation