Abstract
It is a widely known theoretical derivation, that the firm’s leverage is negatively related to volatility of stock returns, although the empirical evidence is still outstanding. To empirically evaluate the leverage we first complement previous simulation studies by deriving theoretical predictions of leverage changes on the volatility smile. Even more important, we empirically test these predictions with an event study using intra-day Eurex option data and a unique data set of 138 ad-hoc news. For our theoretically derived predictions we observe that changes in leverage of DAX companies from 1999 to 2014 cause significant changes to the implied volatility smile.
Highlights
The fact that changes in leverage lead to changes in volatility of stock returns is even before the publication of Modigliani Millers seminal paper a well-known phenomenon
We develop a theoretical proof of the effects of the leverage effect on the level, slope, and curvature on the implied volatility smile in the Geske (1979) compound option model
We concentrate on the level, slope, and curvature of the implied volatility smile
Summary
The fact that changes in leverage lead to changes in volatility of stock returns is even before the publication of Modigliani Millers seminal paper a well-known phenomenon. The main idea behind the theory of this phenomenon is that a firm holds assets and issues equity. The equity holders claim the residual, of which riskiness positively depends on the leverage. Due to option’s implied volatility being linked to realized stock volatility, the implied volatility should depend on the leverage as a ratio. The authors would like to thank Henning J. Fock for his previous work, for the very helpful advice and discussions on this topic. We thank Deutsche Gesellschaft für Ad-hoc-Publizität mbH for providing us with the ad-hoc news from 1999 to 2014
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