Accounting for Earnings Announcements in the Pricing of Equity Options

December 17, 2014
  • Contributors:

    Tim Leung, Marco Santoli
  • Topic:

    Derivatives

Journal of Financial Engineering

There is a wealth of literature in empirical finance and accounting that examines how earnings announcements affect stock and option prices. Most of the studies focus on the informational content, market reactions and price patterns associated with earnings releases. In this paper, we adopt a different approach.

We analyze an option pricing framework that accounts for the price impact of an earnings announcement, with emphasis on the behavior of the implied volatility prior to the event. Specifically, we introduce a random-sized jump scheduled on the earnings announcement date to represent the shock to the company stock price.

As options are intrinsically forward-looking contracts, their prices should account for the uncertain stock price impact of an upcoming earnings release. A natural question is how to extract some information on such an impact from observed options prices, especially a few days before the announcement. Since traders often quote or study the implied volatility for each option, in practice it is important to better understand the behavior of the pre-earnings announcement implied volatility.



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