This thesis examines the kind of information “informed” traders have prior to a takeover announcement using options of target firms. I find that option liquidity rises before a takeover announcement, indicating the presence of informed traders. Using 2,390 M&A events, I show that the implied volatility (IV) skew and the relative option-to-stock trading volume O/S predict negatively on target announcement returns, but that the difference between implied volatilities of calls and puts (IV spread) has no predictive power. The main results indicate that the predictive power of these three informed option trading proxies increases if target management is entrenched and if the bidder and the target are in the same industry. I conclude that informed trading is partially driven by industry insiders with specific knowledge about the future acquisition. However, the results are only significant for one or two informed option trading proxies at a time.
Table of Contents
1. Introduction
2. Literature Review
2.1 The value of mergers and acquisitions
2.1.1 Occurrence and characteristics
2.1.2 Event studies on the wealth effects of acquisitions
2.1.2.1 Abnormal returns methodology
2.1.2.2 Takeover premiums
2.1.2.3 Bidding firms' announcement returns
2.1.3 Disentangling synergistic gains and other informational effects
2.1.3.1 Information asymmetry and the method of payment
2.1.3.2 Revelation, truncation, and information timing
2.2 Cross-section of options and stocks: Evidence from M&A transactions
2.2.1 Price discovery process in the options and stock market
2.2.1.1 Definitions
2.2.1.2 The role of informed traders
2.2.1.3 The predictive power of option implied volatilities
2.2.2 Event studies: predicting announcement returns with option trading proxies
2.2.2.1 Trading activity around corporate announcements (earnings)
2.2.2.2 Predictability of M&A announcement returns
2.3 Conceptual framework and hypothesis development
3. Data and methodology
3.1 Data
3.2 Methodology and Summary Statistics
3.2.1 Cumulative abnormal returns
3.2.2 Primary explanatory variables
3.2.3 Hypothesis testing
3.2.3.1 Pre-announcement liquidity
3.2.3.2 Cross-sectional regression and control variables
3.2.3.3 Effect of deal characteristics on CAR predictability
4. Empirical results
4.1 Option liquidity
4.2 Predictive power of options for CARs
4.2.1 Sorted portfolio approach
4.2.2 Regression results
4.2.3 Deal and target characteristics
4.2.4 Significance of the results
5. Conclusion
Research Objectives and Themes
The primary research objective of this thesis is to investigate the nature of information possessed by "informed" traders regarding target firms and specific deal attributes prior to the public announcement of a takeover. The thesis seeks to determine whether informed option trading proxies—specifically implied volatility spread, implied volatility skew, and the relative option-to-stock trading volume—can effectively predict target announcement returns.
- The relationship between informed option trading and target firm takeover premiums.
- The impact of deal characteristics, such as financing method, on option trading predictability.
- The role of managerial entrenchment in influencing informed trading behavior.
- The informational advantage of industry insiders in the options market.
- The effectiveness of option markets versus stock markets for informed traders.
Excerpt from the Book
2.2.1.1 Definitions
According to basic financial theory, an option is a redundant security whose price is derived from an “underlying,” i.e. from a primary instrument such as a stock. Nevertheless, options can also be written on commodities, futures, and basically all assets that have an observable market price. In terms of stock options, redundancy means that every option can be replicated by a combination of the underlying stock and a risk-free bond. This holds, however, only in complete markets without transaction costs, taxes, arbitrage opportunities, and short selling constraints. The well-known and widely used option pricing model by Black and Scholes (1973) and Merton (1973) (henceforth BSM) builds upon these assumptions and derives the option price from the stock price, the strike price, the risk-free rate, the option’s maturity, and the stock volatility that is expected over the life of the option. While the buyer of a call option has the right (but not the obligation) to buy a certain amount of the underlying for the strike price from the seller (“writer”), a put option entitles the holder to sell the underlying at the strike price. The contract between the buyer and the seller specifies whether the option can be exercised at any time prior to the expiration date (“American” option) or only on the day of expiration (“European” option). The BSM formula can only be applied to European calls and puts on non-dividend paying stocks. Most traded options are, however, American and need to be valued by means of other models, e.g. binomial trees.
In reality, options cannot be perfectly replicated because of transaction costs and the indivisibility of common stocks. Additionally, traders with negative private information often have no choice but to trade options in lieu of stock due to short selling constraints in the stock market. Option prices are determined by the trading activity in both stock and options markets. The large trading volumes that can be observed in the market indicate that investors take on substantial positions in derivatives. It can therefore be concluded that options are in fact non-redundant securities that are value-adding to at least some market participants.
Summary of Chapters
1. Introduction: This chapter introduces the role of informed traders in financial markets and establishes the core research question regarding what information these traders possess before M&A announcements.
2. Literature Review: The chapter synthesizes existing academic literature on mergers and acquisitions, asset pricing, and the role of option markets in price discovery to form a conceptual framework.
3. Data and methodology: This section details the sample construction from SDC Platinum and OptionMetrics, and outlines the event study and regression models used to test the hypotheses.
4. Empirical results: The findings from the tests on option liquidity, option predictability for CARs, and the impact of deal/target characteristics are presented and analyzed.
5. Conclusion: The final chapter summarizes the research findings, acknowledges limitations, and provides suggestions for future research in the field of informed trading.
Keywords
Informed option trading, mergers and acquisitions, target firms, takeover premiums, implied volatility spread, implied volatility skew, option-to-stock volume ratio, price discovery, event study, managerial entrenchment, market efficiency, informational asymmetry, corporate finance, deal financing, insider trading.
Frequently Asked Questions
What is the core subject of this thesis?
The thesis examines the behavior and information set of "informed" traders in the options market prior to official takeover announcements concerning target firms.
What are the central research themes?
The work focuses on whether option trading characteristics—namely IV spread, IV skew, and option-to-stock volume ratios—can predict takeover announcement returns, while considering the influence of firm and deal attributes.
What is the primary research goal?
The goal is to determine what specific information informed traders have about target firms and deal terms before a takeover is made public, and whether they utilize options to capitalize on this information.
Which scientific methodology is applied?
The author employs a standard event study methodology using cumulative abnormal returns (CARs), supported by logit regressions for probability assessment and cross-sectional regressions to test the predictive power of trading proxies.
What does the main body cover?
The main body summarizes the literature, describes the data collection from databases like SDC and OptionMetrics, explains the empirical models, and discusses the regression results regarding option liquidity and announcement returns.
Which keywords best characterize this work?
Key concepts include informed option trading, takeover premiums, implied volatility metrics, and informational asymmetry in the M&A market.
How does managerial entrenchment affect the findings?
The study finds that managerial entrenchment increases the expected takeover premium, prompting better-informed traders to increase their option activity despite the illiquidity of the target firms' options.
What role does industry affiliation play in the results?
The results indicate that predictability is stronger when both the bidder and target are in the same industry, suggesting that industry-specific know-how provides an informational advantage to traders.
Why are target firms prioritized over bidding firms?
Target firms are chosen because their shareholders receive significant takeover premiums, making them potentially more attractive to informed traders compared to the often negative or marginal returns for acquiring firm shareholders.
Are the conclusions regarding informed trading definitive?
The author concludes that while results support the presence of informed trading, they are statistically weak, suggesting that future research is needed to validate these findings with larger or more granular datasets.
- Citation du texte
- Marco Klapper (Auteur), 2013, The nature of informed option trading, Munich, GRIN Verlag, https://www.grin.com/document/262182
