An Empirical Examination of the Relation between the Option-Implied Volatility Smile and Heterogeneous Beliefs

Abstract

An option contract is a zero-sum game, so two identical risk-averse investors would never take opposite sides of it. While they will agree on the correct option price, they would never trade with each other. Heterogeneity is essential for options trading to exist, and aggregating diverse expectations into a single market clearing price is an important function of any derivatives market. In this article, the authors look at the impact of heterogeneous beliefs about earnings, as reflected in the dispersion of analysts’ forecasts in the IBES database. The effect on the market is measured by the slopes of the volatility smile for out-of-the-money (OTM) minus at-the-money (ATM) puts (left side of the smile) and OTM minus ATM calls (right side). Smiles for individual stocks are higher and more smile-shaped than for the SPX index and show significant and interesting effects from the explanatory variables, including firm size, liquidity, market volatility, and book-to-market. But controlling for those effects, dispersion in earnings forecasts raises OTM IVs relative to ATM IVs, both in regressions and in portfolio sorts. Interesting differences appear between systematic and idiosyncratic components of the smile slope, with systematic effects especially important for OTM puts, while OTM calls are more influenced by the idiosyncratic component.

TOPICS: Options, quantitative methods