Firm Fundamentals and the Cross Section of Implied Volatility Shapes

Abstract

We investigate whether firm fundamentals can explain the shape of option implied volatility (IV) curve. Extending Geske's (1977) compound option model, we link firm fundamentals to the IV curve theoretically. Using options on all available US-listed companies, we find empirically that leverage, dividend policy, cost of capital are important determinants of the IV curve even after controlling for historical volatility, risk-neutral skewness, kurtosis and systematic risk ratio. Moreover, firm fundamentals not only have statistically and economically explanatory power on the IV curve, but also help reconcile with some important stylized facts and puzzles in the option pricing literature.