Learning about Uncertainty from Options Trading

Abstract

We hypothesize that managers can learn about a firm’s investment uncertainty from the equity options market. Using a US sample of 1,865 merger and acquisition attempts during 1996–2015, we show that the volatility implied from an acquiring firm’s equity options around an acquisition announcement negatively predicts the likelihood of acquisition attempts being completed. This negative impact is robust to controls for stock prices, alternative uncertainty proxies, and endogeneity tests. Moreover, we document three economic channels, finding that the effect of option implied volatility on deal completion is stronger among acquirers in which disinvestment is more difficult, whose managers are more susceptible to risk aversion, and whose options market is expected to have more information. Our findings suggest that options trading functions as a feedback mechanism to help managers learn about riskiness when making investment decisions.