Informational Content of Option Trading on Acquirer Announcement Return * National Chengchi University. The University of Hong Kong.

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1 Informatonal Content of Opton Tradng on Acqurer Announcement Return * Konan Chan a, b,, L Ge b,, and Tse-Chun Ln b, a Natonal Chengch Unversty b The Unversty of Hong Kong Aprl, 2012 Abstract Ths paper examnes the nformatonal content of opton tradng n merger and acquston (M&A) events. We fnd that pre-m&a announcement opton tradng contans nformaton on acqurer announcement returns. Usng 5,099 M&A events from 1996 to 2010, we show that mpled volatlty (IV) spread predcts postvely on the announcement return, whle mpled volatlty (IV) skew predcts negatvely on the announcement return. The result s stronger f the opton lqudty s hgh and stock lqudty s relatvely low. We also fnd some supportng evdence n post-m&a long-run performance for acqurers, usng calendar-tme portfolo regresson, post-m&a one-year buy-and-hold abnormal returns, and cumulatve abnormal returns around post-m&a quarterly earnngs announcement days. We show that hgher IV spread and lower IV skew are assocated wth better long-run abnormal performance. Moreover, we use the relatve tradng volume of optons to stock (O/S) as an alternatve proxy for nformed opton tradng actvty, and show that hgher O/S predcts hgher acqurer absolute announcement return. A pre-event prce run-up mtgates the predctve power of O/S. Our man result remans consstent among a smaller sample of target frms. JEL Classfcaton: G12, G14, G34 Keywords: Merger and Acquston, Acqurer, Informed Tradng, Impled Volatlty Spread, Impled Volatlty Skew * We have benefted from the comments of Gurdp Baksh Utpal Bhattacharya, Jngzh Huang and Nel Pearson. Tse-Chun Ln gratefully acknowledges the research support from the Faculty of Busness and Economcs at the Unversty of Hong Kong and the Research Grants Councl of the Hong Kong SAR government. All errors reman our responsblty. Tel.: ; fax: E-mal address: Tel.: ; fax: E-mal address: Tel.: ; fax: E-mal address:

2 I. Introducton Prevous lterature has documented that nformed nvestors trade n optons market to captalze on ther prvate nformaton. Easley, O Hara, and Srnvas (1998) argue that nformed traders would prefer optons market when mplct leverage n optons s hgh and optons are relatvely lqud compared wth stocks. One stream of the emprcal studes adopts several nformed tradng measures n optons market to predct future stock returns. Pan and Poteshman (2006) fnd that stocks wth low put-call ratos outperform those wth hgh put-call ratos on the next day and over the next week. Cremers and Wenbaum (2010) document that the devaton from put-call party contans nformaton about frm s stock return n the followng week. Xng, Zhang, and Zhao (2010) show that stocks wth hgher mpled volatlty (IV) skew experence lower future returns, and the predctablty of IV skew perssts for at least half a year. Johnson and So (2011) fnd that the rato of optons to stock tradng volume (O/S) s negatvely related to stock returns n the next month. Another stream of research focuses on the relatonshp between pre-event nformed opton tradng and the content and market reacton of corporate news. For example, Roll, Schwartz, and Subrahmanyam (2010) fnd a postve predcton of O/S on the absolute return around earnngs announcement. Chan, L and Ln (2012) fnd a strong correlaton between pre-splt nformed opton tradng measures (O/S, IV spread, and IV skew) and splt announcement returns, whch supports the sgnalng hypothess. Dressen, Ln, and Lu (2012) show that standardzed unexpected earnngs, analyst recommendaton changes, and analyst forecast changes can be predcted by IV spread and IV skew. However, lttle attenton has been pad to whether opton tradng actvtes contan nformaton on the most mportant corporate event,.e., merger and acquston (M&A). 1 We fll ths lterature gap by testng the followng man hypothess: does opton tradng contan nformaton on M&A acqurer announcement return? Specfcally, we adopt two opton measures,.e. IV spread n Cremers and Wenbaum (2010) and IV skew n Xng, Zhang, and Zhao (2010), to test ther predctablty on acqurer announcement return. We subsequently provde more supportng evdence by answerng two addtonal questons. Does the relatve lqudty of opton 1 One excepton s Cao, Chen, and Grffn (2005) who adopt opton volume mbalance to predct M&A target announcement return. 1

3 to stock affect the predctablty of our nformed opton tradng measures? Do the nformed opton tradng measures predct long-run equty performance? We focus on acqurers because many targets are prvate frms wthout stock and optons tradng, and acqurers are of more mportance due to ther larger market captalzaton. Emprcally, our sample covers M&A events from the Securtes Data Company (SDC) Platnum database for the perod of 1996 to For each acqurer, we obtan ts daly optons data from OptonMetrcs to construct our proxes for nformed opton tradng. The IV spread measures the average dfference of mpled volatltes between call and put optons on the same securty wth the same strke prce and maturty. Intutvely, a larger IV spread means that calls are more expensve compared wth puts, ndcatng a hgher buyng pressure on call optons. 2 On the other hand, the IV skew measures the dfference between mpled volatltes of out-of-the-money (OTM) put and at-the-money (ATM) call. A hgher IV skew ndcates that nvestors demand more OTM puts, expectng a drop n the future stock prce. 3 Usng the two nformed opton tradng measures one day before M&A announcement, we fnd that a hgher IV spread predcts a hgher acqurer cumulatve abnormal return (CAR), whle a hgher IV skew predcts a lower acqurer CAR. IV spread s postve and strongly sgnfcant by tself. The coeffcent for IV spread s 8.90 wth a t-statstc of 3.66 when controllng frm and deal characterstcs. On the other hand, IV skew carres a negatve and sgnfcant coeffcent by tself. The coeffcent for IV skew s wth a t-statstc of when addng control varables. Both results are consstent wth our hypothess. We then conduct addtonal tests to support the man fndngs. Frst, we show that the predctve power of opton measures s stronger f the acqurer s opton lqudty (measured by bd-ask spread) s relatvely hgh and stock lqudty (measured by Amhud (2002) llqudty rato, ILLIQ) s relatvely low. The opton predctablty s weaker f the acqurer has low opton lqudty but relatvely hgh stock lqudty. These results are n lne wth the model n Easley, O Hara, and Srnvas (1998). 2 For mpled volatlty spread, see among others, Bal and Hovakman (2009), Chan, L and Ln (2012), Dressen, Ln, and Lu (2012), Jn, Lvnat, and Zhang (2012). 3 For mpled volatlty skew (or smrk), see among others, Bester, Martnez, and Rosu (2011), Bollen and Whaley (2004), Buskrk (2011), Chan, L and Ln (2012), Dressen, Ln, and Lu (2012), Jn, Lvnat, and Zhang (2012). 2

4 Second, we show that pre-event nformed opton tradng measures are also related to acqurer long-run performance. We frst sort our sample nto quartles based on IV spread or IV skew. Adoptng calendar-tme portfolo regresson (Fama, 1998; Ikenberry and Ramnath, 2002), we fnd that acqurers n the bottom IV skew quartle exhbt hgher abnormal returns n one-year horzon, compared wth those n the top IV skew quartle. The return spread s large and sgnfcant. We also dscover smlar patterns for IV spread sortng, although the return spread s not sgnfcant. When usng post-m&a buy-and-hold abnormal return (BHAR) and quarterly earnngs announcement CAR as alternatve ndcators of long-run performance, the evdence s consstent wth calendar-tme portfolo approach. In sum, pre-event IV spread (IV skew) has a postve (negatve) predcton on acqurer long-term performance. Thrd, we adopt O/S, based on unsgned volume, as an addtonal measure of nformed tradng. Accordng to Roll, Schwartz, and Subrahmanyam (2010), O/S s expected to be postvely correlated wth absolute value of event announcement return. 4 We fnd that hgher pre-event O/S ndcates a hgher absolute acqurer CAR, wth a coeffcent of 0.25 and t-statstc of We also conjecture that f nformed nvestors trade on ther prvate nformaton before announcements, pre-event prces wll partally ncorporate the nformaton. As a result, the announcement returns wll be smaller n magntude. Our fndngs show that a pre-event prce run-up reduces the predctve power of O/S on absolute acqurer CAR. Fnally, our man results are robust to several alternatves of constructng nformed opton tradng measures, such as usng decles of IV spread or IV skew, changes of IV spread or IV skew compared wth prevous week or compared wth prevous month as the man explanatory varables. Excludng events wth small deal value or small market captalzaton does not affect our results. Moreover, we fnd consstent results of IV spread and IV skew n predctng target announcement CAR. However, due to a smaller number of optoned target frms, the analyss of IV spread lacks statstcal power. Our paper s most related to Cao, Chen, and Grffn (2005), who employ call and put opton volume mbalances to predct CARs of target frms. Our paper dffers from and yet complements ther research n three key aspects. Frst, we nvestgate the nformatonal content of opton tradng on acqurer announcement return (5,099 events), whle they study a smaller sample of 4 For O/S, see among others, Chan, L and Ln (2012), Johnson and So (2011). 3

5 target announcement return (78 events). Second, we cover an updated M&A sample from 1996 to 2010, whle ther M&A events occur between 1986 and Last, to capture the prvate nformaton held by nformed opton traders, we ncorporate two newly-developed proxes for demand pressure based on daly mpled volatlty, whle they construct sgned volume mbalance usng Lee and Ready (1991) algorthm based on ntraday trade and quote data. The rest of the paper s organzed as follows. Secton II descrbes M&A sample and the two man opton measures we use. Secton III presents the man hypothess and results n sortng and crosssectonal regressons. In Secton IV, we provde supportng evdence by consderng lqudty role of opton and stock, the long-run performance, the predctablty of O/S, and other alternatve constructons of opton tradng measures as robustness check. Then we test our man hypothess on target frms n Secton V. Secton VI concludes the paper. II. Data A. M&A sample Our M&A sample covers the perod of January 1996 to December 2010, obtaned from Securtes Data Company (SDC) platnum database. For each acqurng frm, we obtan daly optons data from OptonMetrcs. We requre the acqurer to be lsted n NYSE or AMEX or NASDAQ, wth daly stock tradng record n CRSP and yearly accountng nformaton n COMPUSTAT. In order to examne the predctablty of pre-event nformed opton tradng, we only keep those frms whch already have daly optons tradng data before they announce the M&A events. We retan those events whch are classfed as merger or acquston of a majorty nterest, because they are most relevant to our study and contan relatvely more transactons. We then exclude the events f the same acqurer announces to merge wth or acqure several dfferent target frms on the same day, because the acqurer announcement return wll be affected by several events smultaneously. [Table 1 about here] Panel A of Table 1 shows the summary statstcs for M&A acqurers. Our fnal sample conssts of 5,099 events and 1,754 acqurng frms. The event number dffers from frm number because some acqurers conduct several M&A actvtes durng the sample perod. Consstent wth 4

6 prevous lterature (e.g. Moeller, Schlngemann, and Stulz, 2004; Moeller, Schlngemann, and Stulz, 2005), there are relatvely more events occurred n late 1990s. In Panel B, we lst the summary statstcs for acqurer CARs by year. CAR s calculated by cumulatng the abnormal returns from day t to t+1, where day t s the announcement date, or the frst tradng day after announcement f the announcement date s a non-tradng day. We use CRSP value-weghted market return as the benchmark when calculatng daly abnormal return. The mean of the acqurer CAR s -0.07%, and ts standard devaton s 6.06%. Consstent wth pror studes (e.g. Harford, Jenter, and L 2011), the mean CAR for acqurer s slghtly negatve and close to zero. If we classfy M&A events by the prmary payment method, t can be shown that the mean announcement return for events wth cash-only payment s much hgher than that for events wth equty shares payment. Ths s consstent wth prevous researches such as Loughran and Vjh (1997) and Netter, Stegemoller, and Wntok (2011). It supports the market tmng story that acqurng frms make use of overvalued equty to purchase hard assets, and as a result, ther stock returns decrease later (Savor and Lu, 2009). B. Impled volatlty spread To examne the nformatonal content of opton tradng, we make use of two opton measures newly adopted n recent lterature. The frst one s IV spread, whch s regarded as a proxy for prce pressure n optons market. To measure devatons from put-call party, IV spread s constructed as the average dfference n mpled volatltes between call and put optons for the same securty wth the same strke prce and the same maturty. In partcular, we compute IV spread for each frm on each day t as follows. IV Spread N, t calls puts, t IV, t IV, t j 1 w j, t ( IV call j, t [Table 2 about here] IV put j, t ) (1) The detaled constructon procedure s ncluded n Appendx. Table 2 Panel A summarzes the IV spread by year. In general, IV spread s negatve, wth a sample mean of and a 5

7 standard devaton of As a drectonal measure of nformed opton tradng actvty, IV spread can predct both postve and negatve future abnormal returns. Intutvely, f call optons are more expensve than put optons, the mpled volatltes of calls wll be hgher than those of puts, leadng to a postve IV spread. A larger (especally ncreasng) IV spread means that nvestors demand more call optons, expectng a postve abnormal return on that stock, whch cannot be explaned by short sale constrants 5. On the contrary, a smaller (especally decreasng) IV spread s assocated wth a negatve future abnormal return. Therefore, f opton nvestors hold prvate nformaton on an M&A event, we would expect that pre-event IV spread s postvely related to the announcement return. C. Impled volatlty skew The other opton measure we adopt s IV skew, whch s used as a proxy for negatve prce pressure n the optons market. We calculate daly IV skew for frm on day t, as the mpled volatlty dfference between out-of-the-money (OTM) put and at-the-money (ATM) call. IV Skew t IV OTMput t IV ATMcall t (2) The constructon detals are descrbed n Appendx. As shown n Panel B of Table 2, IV skew s generally postve, wth a sample mean of and a standard devaton of IV skew s also a drectonal measure on nformed opton tradng. If nvestors hold negatve nformaton, they tend to buy put optons, especally the OTM puts, ether to hedge aganst future prce drop or to speculate on the potental return on longng put optons. If more nvestors are wllng to buy OTM puts, the prces and mpled volatltes of OTM puts wll be pushed up, and IV skew wll ncrease. Therefore, a hgher demand for OTM put optons ndcates that nvestors hold negatve news on the frm s future stock returns. ATM call s used as the benchmark snce t s the most lqud opton whch should reflect nvestors consensus about the uncertanty of the frm. The ratonale of IV skew s consstent wth the mpled volatlty functons measured by delta n Bollen and Whaley (2004). In M&A events, we expect a negatve relatonshp between preannouncement IV skew and the announcement return. 5 See Cremers and Wenbaum (2010). 6

8 III. Man hypothess and results Ths secton dscusses our man hypothess that opton tradng pror to an M&A event contans nformaton on acqurer announcement return. As mentoned n the prevous secton, we use two drectonal measures of nformed opton tradng,.e. IV spread and IV skew, to test whether they can predct acqurer announcement CAR. A. Acqurer announcement CARs sorted by IV spread and IV skew To show the relatonshp between announcement returns and nformed opton tradng measures, we sort the sample nto quntles based on pre-announcement IV spread and IV skew respectvely. We expect that the acqurer announcement return wll ncrease wth the value of IV spread and decrease wth the value of IV skew. [Table 3 about here] Table 3 shows the mean and t-statstcs of acqurer CARs for each quntle of IV spread or IV skew. CARs are cumulated from day t to t+1 where day t s the announcement date, or the frst tradng day after announcement f that day s a non-tradng day. We use day t-1 value of IV spread and IV skew, because the nformatonal advantage of nformed traders should be largest rght before corporate events, as argued by Sknner (1997). Quntle 1 contans acqurers wth the lowest 20% of IV spread or IV skew and quntle 5 contans those wth the hghest 20%. In terms of IV spread sortng, mean CAR s negatve for all but the hghest quntle. Consstent wth expectaton, CAR s generally ncreasng wth IV spread. The hgh-mnus-low column shows the dfference between quntle 5 and quntle 1. It s sgnfcant and postve, wth a mean of 0.90% and a t-statstc of We also dscover that CAR s decreasng wth IV skew n a monotonc pattern. Except quntle 1, each quntle has a negatve mean CAR, whch s especally sgnfcant n the hghest IV skew quntle. The decrease of CAR s dramatc between quntle 1 and 2, and between quntle 4 and 5. Hgh-mnus-low dfference equals -1.37% whch s sgnfcant wth a t statstc of From the sngle sortng result, we obtan prelmnary supportng evdence for our man hypothess. Acqurer announcement return s postvely correlated wth IV spread and negatvely 7

9 correlated wth IV skew. In the next subsecton, we present cross-sectonal regresson results to further support and confrm our hypothess. B. Hgher IV spread or lower IV skew s assocated wth hgher acqurer announcement CAR We argue that a hgh IV spread reflects nvestors expectaton on future prce ncrease, whle a hgh IV skew reflects nvestors expectaton on a downward prce change. We have dscovered the monotonc relatonshp between acqurer announcement CAR and pre-event opton measures from the sortng results. In ths subsecton, we formalze the test by runnng cross-sectonal regressons of acqurer announcement returns on nformed opton tradng measures and other control varables. The man regresson s CAR [ t, t 1] 0, 1, IV Spread t 1 ( or IV Skew t 1 ) 1, Pre month Return [ t 22, t 1] 2, Pre year Return [ t 252, t 23] 3, Successful t 4, Takeover t 5, Hostle t 6, Rumor. t 7, Cash. t 8, Sze t 9, B / M t 10, Year Fxed Effect 11, Industry Fxed Effect (3) where CAR [t, t+1] s the cumulatve abnormal return from day t to t+1 for each acqurng frm expressed n percentage. The ndependent varables of nterest are IV spread and IV skew on day t-1 for each frm. Duo to the correlaton between IV spread and IV skew, we nclude them n separate regressons. Control varables are then added to the man regresson. Wth pre-month return and pre-year return, we take nto account the prce run-up one year pror to each M&A event. Specfcally, pre-month return s calculated as the buy-and-hold return compounded from day t-22 to t-1, and pre-year return s the buy-and-hold return compounded from day t-252 to t-23. We also consder event-related characterstcs whch may affect announcement returns of acqurers. Smlar to Cao, Chen, and Grffn (2005), we add fve event-related dummes. Successful equals 1 f the merger or acquston s successfully completed,.e. the status s C as ndcated n SDC, and 0 otherwse. Takeover equals 1 f the event s classfed as an acquston of a majorty nterest nstead of a merger n SDC, and 0 otherwse. Hostle equals 1 f the event s atttude s dentfed as hostle n SDC, and 0 otherwse. Rumor equals 1 f there s pre-event rumor,.e. the secton of deal began as a rumor s yes, and 0 otherwse. Cash 8

10 equals 1 f the prmary payment s cash,.e. the % of cash s greater than or equal to 50, and 0 otherwse. We then control for frm characterstcs. Sze s the natural logarthm of market captalzaton on the event day t. Book value s calculated as book value per share multpled by total shares outstandng, where we use the most recent fscal year end data pror to each event. B/M s natural logarthm of the rato of book value to market captalzaton. We also nclude year and ndustry fxed effects. [Table 4 about here] As shown n Table 4 Panel A, pre-event IV spread has a sgnfcantly postve predcton on acqurer announcement CAR. To control for heteroskedastcty, we report t-statstcs calculated usng Whte s (1980) heteroskedastcty robust standard errors for all regressons. When IV spread s the only explanatory varable, t has a postve and sgnfcant coeffcent of 8.99 wth a t-statstc of In column (2) to (5), we gradually add controls for prevous returns, eventrelated characterstcs, and frm characterstcs. Ths does not affect the predctablty of IV spread on acqurer announcement return. When we nclude all control varables as well as year and ndustry fxed effects, IV spread stll has a coeffcent of 8.90 and a t-statstc of When IV spread ncreases by one standard devaton, the acqurer announcement CAR wll ncrease by about 0.57%. The takeaway s that hgher IV spread s a proxy for postve nformaton held by opton traders, thus t predcts a hgher acqurer announcement CAR, and vce versa. Smlarly, we test the predctablty of IV skew on acqurer announcement return, and the regresson results are presented n Panel B of Table 4. A hgher IV skew s a proxy for a hgher buyng pressure on OTM put optons. It ndcates that nvestors are expectng a negatve return on the stock. As shown n Panel B column (1), IV skew tself carres a coeffcent of wth a t-statstc of Addng all control varables does not affect the negatve relatonshp between IV skew and acqurer CAR (β 1 = -8.88, t-statstc = -2.24). One standard devaton ncrease of IV skew wll lead to a decrease of the acqurer announcement CAR by about 0.48%. To sum up, our man hypothess s well supported by cross-sectonal regressons. Opton traders do hold prvate nformaton and trade on t before the announcement of an M&A event. The IV spread s postvely assocated wth the acqurer announcement return, whle the IV skew s 9

11 negatvely assocated wth t. The predctablty remans sgnfcant when we control for other factors that may affect event wndow returns. IV. Addtonal tests and robustness check In ths secton, we extend our man hypothess n three aspects,.e. the role of opton and stock lqudty, long-run performance, and the predctablty of O/S. We then provde evdence usng dfferent varatons of IV spread and IV skew as robustness check. A. The role of lqudty Ths subsecton dscusses the role of relatve lqudty of opton to stock for an M&A acqurer. Easley, O Hara, and Srnvas (1998) argue that there wll be more nformed tradng n optons market f optons are relatvely more lqud than stock, and less nformed opton tradng f stock s relatvely more lqud. A natural extenson s to examne whether the predctablty of IV spread and IV skew on acqurer announcement return wll be affected by the relatve lqudty of opton to stock. We expect that the predctve power wll be strengthened f opton lqudty s relatvely hgh and stock lqudty s relatvely low, and vce versa. We measure opton lqudty by bd-ask spread. For each opton on each day, we calculate the dfference between best offer and best bd prce, and then dvde t by the average of the two. It s a proxy for the cost pad by opton traders. The hgher the bd-ask spread, the lower the lqudty of opton. We take the average bd-ask spread across all non-zero tradng volume optons for each frm on each day, and then use the average from day t-5 to t-1 as a proxy for the acqurer s opton lqudty before each M&A event. To measure stock lqudty, we adopt Amhud (2002) llqudty rato (ILLIQ), whch s calculated as the daly rato of the absolute stock return to ts dollar tradng volume, averaged over day t-5 to t-1 for each M&A acqurer. A hgher ILLIQ means lower stock lqudty n preevent fve days. For each announcement on day t, we calculate opton lqudty for all of the frms n the market wth non-zero opton tradng volume durng day t-5 to t-1. After that, we sort all these frms nto 10

12 quartles based on opton lqudty and dentfy whch quartle the acqurer belongs to. Quartle 1 has the lowest opton lqudty (hghest bd-ask spread), and quartle 4 has the hghest opton lqudty (lowest bd-ask spread). We then sort events n each opton lqudty group based on acqurer s stock lqudty, where quartle 1 has the lowest stock lqudty (hghest Amhud ILLIQ) and quartle 4 has the hghest stock lqudty (lowest Amhud ILLIQ). Smlar to the approach used n Cremers and Wenbaum (2010), we create two dummy varables based on the above lqudty measures. The dummy Hgh Opton Low Stock Lq equals 1 for acqurer stocks that are both n the hghest 25% of opton lqudty and n the lowest 25% of stock lqudty, and 0 otherwse. Low Opton Hgh Stock Lq equals 1 for acqurer stocks that are both n the lowest 25% of opton lqudty and n the hghest 25% of stock lqudty, and 0 otherwse. These dummy varables are nteracted wth each of our nformed opton tradng measures. The regressons are as follows, CAR [ t, t 1] 0, 1, IV Spread t 1 2, IV Spread t 1 * Hgh Opton Low Stock Lq 3, IV Spread t 1 * Low Opton Hgh Stock Lq Control Varables (4a) CAR [ t, t 1] 0, 1, IV Skew t 1 2, IV Skew t 1 * Hgh Opton Low Stock Lq 3, IV Skew t 1 * Low Opton Hgh Stock Lq Control Varables (4b) where CAR [t, t+1] refers to the cumulatve abnormal return for acqurng frm from day t to t+1, IV spread and IV skew are day t-1 measures for nformed opton tradng, Hgh Opton Low Stock Lq and Low Opton Hgh Stock Lq are dummy varables defned as n the prevous paragraph. We use the nteracton terms of nformed tradng measures wth lqudty dummes to gauge the return predctablty for acqurers wth dfferent relatve lqudty of opton to stock. All control varables are the same as n regresson equaton (3). [Table 5 about here] As shown n the frst three columns of Table 5, IV spread stll has a postve predcton on acqurer announcement return. Consstent wth expectaton, the coeffcent on IV spread * Hgh Opton Low Stock Lq s postve (β 2 = 1.49 n column (3)), ndcatng that IV spread has a stronger predctve power when opton lqudty s relatvely hgh and stock lqudty s relatvely 11

13 low. On the other hand, the coeffcent on IV spread * Low Opton Hgh Stock Lq s negatve and sgnfcant (β 3 = n column (3)). It means that the predctve power wll be much smaller f opton lqudty s low whle stock lqudty s relatvely hgh. The last three columns of Table 5 present the results for IV skew whch stll shows a sgnfcantly negatve predcton on acqurer CAR. The coeffcent on IV skew * Hgh Opton Low Stock Lq s negatve and sgnfcant (β 2 = n column (6)), whle the coeffcent on IV skew * Low Opton Hgh Stock Lq s postve (β 3 = n column (6)). It supports our argument that hgh opton lqudty, relatve to stock lqudty, strengthens the predctve power of IV skew, and vce versa. Concur wth the results n Easley, O Hara, and Srnvas (1998) and Cremers and Wenbaum (2010), we fnd that lqudty plays a sgnfcant role when nvestors choose whch market to trade n. When opton has a hgh lqudty, nformed nvestors may trade more actvely n opton to take advantage of ts hgh leverage and low cost. As a result, opton tradng wll contan more nformaton about the M&A events, and our opton measures wll have stronger predctve power on M&A announcement returns. Conversely, f opton s less lqud, nformed traders may nvest more n stock market. There wll be less nformaton revealed n pre-m&a opton tradng and less predctablty of our opton measures on announcement returns. B. Long-run performance We have shown the predctablty of nformed opton tradng on acqurer short-term CAR around M&A announcement. One may wonder that whether pre-m&a nformed opton tradng s also related to acqurer s long-run performance. If nformed nvestors hold vtal nformaton about the value creaton through the M&A events, one would expect that the pre-m&a nformed opton tradng predcts frm long-run performance. In other words, frms wth hgher IV spread or lower IV skew are expected to generate hgher long-run abnormal returns, and frms wth lower IV spread or hgher IV skew are expected to generate lower long-run abnormal returns. Followng Fama (1998) and Ikenberry and Ramnath (2002), we frst measure long-run abnormal return by calendar-tme portfolo regresson whch exhbts better statstcal propertes and mtgates the cross-sectonal correlatons. We sort all acqurers nto quartles based on ther pre- 12

14 announcement IV spread and IV skew respectvely. Wthn each quartle, we add acqurers nto portfolo n the next month after they announce M&A events, and hold them for 12 months. The portfolo s rebalanced n each month. Monthly portfolo return s calculated based on equalweghted nvestment strategy to take advantage of ts better dversfcaton and lower dosyncratc nose. We also vary the holdng perod from one year to fve years. For each of the calendar-tme portfolos, we measure abnormal returns usng Carhart (1997) 4- factor model, whch takes the form R R 1 ( Rmkt, t Rrf, t ) 2 RSMB, t 3 RHML, t 4 RPR 1, p, t rf, t YR t t (5) where R p,t s monthly portfolo return, R rf,t s rsk-free rate, R mkt,t - R rf,t s market premum, R SMB,t s the small-mnus-bg market captalzaton factor, R HML,t s the hgh-mnus-low book-to-market factor, and R PR1YR,t s the momentum factor. α measures long-run abnormal performance. Snce the M&A events are not unformly dstrbuted n tme, we adopt weghted least squares (WLS), where the weghts are the number of acqurers n the portfolo n each month. Ths approach ensures that each acqurer has the same mpact n the analyss. We apply Newey-West (1987) standard errors to adjust for heteroskedastcty and autocorrelaton. [Table 6 about here] Panel A of Table 6 shows the one-year to fve-year abnormal returns for each IV spread and IV skew quartle. The last column presents the return spread between Quartle 4 and Quartle 1. Consstent wth our expectaton, acqurers wth hgher IV spread (lower IV skew) performs better than those wth lower IV spread (hgher IV skew) n the long-run. In one-year horzon, the top IV spread quartle frms earn 0.08% per month on average, whle the bottom IV spread quartle frms lose 0.20% per month on average. There s a return spread of 0.28% per month. Smlarly, the bottom IV skew quartle frms earn 0.47% per month, whle the top IV skew quartle frms lose 0.36% per month. The one-year abnormal return spread amounts to -0.83% per month, whch s economcally and statstcally sgnfcant. The hgh-mnus-low dfference s largest for one-year abnormal returns and t decreases gradually wth tme. The results suggest that opton traders hold some nformaton on frm performance beyond one year, and nformed opton tradng measures can also predct acqurer long-run returns. 13

15 We also adopt buy-and-hold abnormal return (BHAR) as another measure for long-run abnormal performance. For each M&A acqurer we calculate buy-and hold return by compoundng postannouncement daly returns, and use value-weghted market buy-and-hold return as the benchmark. We focus on BHARs for post-m&a announcement one year. 6 To mtgate the effect of extreme values, decles of BHARs are regressed on day t-1 IV spread and IV skew and control varables. As shown n Panel B of Table 6, there s some predctablty of our nformed opton tradng measures on BHAR. The coeffcent on IV spread s postve and sgnfcant by tself and wth all controls (β = 1.62, t-statstc = 1.96 n column (1), β = 1.42, t-statstc = 1.81 n column (3)). A hgher IV spread postvely predcts BHAR n one-year horzon after the M&A announcement. On the other hand, the coeffcent on IV skew s negatve, whch s also consstent wth our conjecture, although nsgnfcant. We then examne whether our nformed opton tradng measures have predctve power on post- M&A earnngs announcement CAR. For each M&A event, we calculate CAR (-1, 1) around each of the four quarterly earnngs announcements after M&A announcement. Followng Dans and Sarn (2001), we regress earnngs announcement CARs on day t-1 IV spread and IV skew. Besdes sze and B/M rato, we also control for change n earnngs whch s the dfference of earnngs between quarter t and quarter t-1, as a percentage of the acqurer s market captalzaton pror to M&A announcement. Panel C shows a postve predctablty of IV spread (β = 3.17, t- statstc = 2.09 n column (3)) and a negatve predctablty of IV skew (β = , t-statstc = n column (6)). Overall, we fnd some supportng evdence on the predctablty of IV spread and IV skew on acqurer long-run performance. We adopt calendar-tme portfolo regresson, and also analyze BHAR as well as earnngs announcement CAR. Generally, a hgher IV spread (or a lower IV skew) s assocated wth a better acqurer long-run performance and a hgher IV skew (or a lower IV spread) s assocated wth a worse long-run performance. 6 We also analyzed BHAR for post-ma& announcement two to fve years, and the regresson results are smlar. For longer holdng perod, both IV Spread and IV Skew show slghtly more sgnfcant predctablty on BHAR. 14

16 C. The predctablty of O/S In prevous analyses, we adopt IV spread and IV skew as proxes for demand pressure n opton tradng. In ths subsecton, we consder the relatve tradng volume of optons to stock (O/S), whch s an unsgned volume-based opton measure. 7 If nvestors hold prvate nformaton on M&A events, they are lkely to trade n both stock market and optons market pror to announcements. Due to the advantage of leverage and lqudty of optons, opton tradng volume should ncrease more than stock tradng volume. As a result, the rato of O/S should ncrease. When the M&A event s a pece of good (bad) news, nvestors may actvely buy (sell) call optons or sell (buy) put optons. In each case, O/S wll be drven up, snce we take nto account both call and put opton tradng wthout separatng whether t s a buy or a sell. We thus conjecture that, f nvestors trade n optons market to captalze on ther prvate nformaton before M&A announcement, pre-event O/S should postvely predct absolute CAR for acqurer. We conduct cross-sectonal regressons as follows, CAR [ t, t 1] 0, 1, Ln( Sh O / S) t 1 Control Varables (6a) CAR [ t, t 1] 0, 1, Ln( Sh O / S) t 1 2, Ln( Sh O / S) t 1 * CAR [ t 3, t 1] Control Varables (6b) where the dependent varable s the absolute value of CAR for acqurer from day t to t+1, and Ln (Sh O/S) s our proxy for nformed opton tradng for day t-1. We construct share volume O/S (Sh O/S) accordng to Roll, Schwartz, and Subrahmanyam (2010). 8 To reduce the nfluence of possble outlers, we take the natural logarthm of Sh O/S. In regresson equaton (6b), O/S s nteracted wth the absolute value of acqurer CAR from day t-3 to t-1. All controls are defned as n equaton (3). [Table 7 about here] In Table 7, the absolute value of acqurer announcement CAR s regressed on Ln (Sh O/S). The frst two columns show a postve and sgnfcant relatonshp between pre-event O/S and 7 For other volume based measures, also see Spyrou, Tsekrekos, and Sougle (2011). 8 For each frm, daly share opton volume s calculated as the total contracts traded n each opton multpled by 100, then aggregated across all optons traded on that stock. (Each contract s for 100 shares of stock.) Share volume O/S (Sh O/S) s the rato of share opton volume to stock tradng volume on that day. 15

17 acqurer announcement return. Wth all control varables as well as year and ndustry fxed effects, O/S has a postve coeffcent of 0.25 wth a large t-statstc of A hgher preannouncement tradng volume of optons relatve to stock s assocated wth a larger absolute announcement return for acqurer. In the last two columns, O/S s nteracted wth the absolute CAR for pre-event three days. Ths term takes nto account the effect of pre-event prce run-up. Our argument s that, the nformed tradng could nduce larger pre-event absolute CAR, so that prvate nformaton wll be partally ncorporated nto acqurer s stock prce before announcement. In that case, O/S s expected to be less nformatve on acqurer announcement return. The coeffcent for ths nteracton term should be negatve, as confrmed by the results n Table 7 (β 2 = -0.04, t-statstc = n column (4)). Ths s consstent wth the fndngs n Roll, Schwartz, and Subrahmanyam (2010), whch nstead studes the predctablty of O/S on earnngs announcements. We also compute dollar volume O/S ($ O/S) as the nformed tradng proxy. 9 The regressons show smlar results as usng share volume O/S. Besdes, we try decles of Sh O/S and decles of $ O/S, and fnd that O/S decles are n general postvely assocated wth acqurer s absolute CAR around announcement. 10 D. Robustness check Ths subsecton provdes several robustness tests on varatons of our opton measures. The predctablty remans sgnfcant when we make use of decles of IV spread and IV skew, and changes compared wth prevous week as well as prevous month. [Table 8 about here] To mtgate the mpact of extreme values of our nformed opton tradng measures, we try to adopt ranks nstead of the raw value of IV spread and IV skew n regressons. As shown n the frst two columns of Table 8, decles of IV spread and IV skew have consstent and sgnfcant 9 Dollar opton volume s calculated by multplyng the total number of contracts traded n each opton by the average of best bd and best offer prce, then multpled by 100. Dollar stock volume equals stock prce multpled by stock tradng volume. Dollar volume O/S ($ O/S) s then calculated as the rato of dollar opton volume to dollar stock volume. 10 See, Johnson and So (2011) for decles of O/S as nformed opton tradng measure. 16

18 predcton on acqurer announcement return. A hgher decle of IV spread ndcates a hgher acqurer announcement CAR (β = 0.11, t-statstc = 3.04), whle a hgher decle of IV skew ndcates a lower acqurer announcement CAR (β = -0.12, t-statstc = -1.95). Other varatons, such as quntles and quartles, gve smlar results. In column (3) and (4), we adopt change n IV spread and IV skew for the prevous week,.e. the dfference between day t-1 and the average from day t-6 to day t-2. Smlarly, n column (5) and (6), we adopt change n IV spread and IV skew for the prevous month,.e. the dfference between day t-1 and the average from day t-23 to day t-2. Intutvely, a large and postve change of IV spread ndcates that nformed nvestors are buyng ncreasngly more calls than puts when the M&A announcement s approachng. It ndcates that nvestors may hold postve nformaton about the event. On the contrary, f IV skew ncreases gradually before the M&A announcement, t s lkely that nvestors are tradng on negatve nformaton, thus they purchase more OTM puts than ATM calls. Usng changes of IV spread and IV skew gve consstent and sgnfcant results as shown n Table 4. Besdes, we also conduct robustness tests by excludng M&A events wth deal value below $10 mllon (about 5% of total observatons) or below $100 mllon (about 32% of total observatons), and the predctablty remans sgnfcant. We also mtgate the effect of small frms by droppng acqurers wth market captalzaton below $400 mllon (about 10% of total observaton), and our results stll hold. To sum up, the results n Secton III and IV ndcate that some nformed nvestors are tradng actvely n optons market pror to announcements, n antcpaton of the M&A events. Both the sgned (IV spread and IV skew) and unsgned (O/S) nformed opton tradng measures have sgnfcant predctve power on acqurer announcement return. The predctablty s affected by the relatve lqudty of optons to stock. Moreover, the nformed opton tradng measures are also related to acqurer long-run abnormal performance. Our results are robust to dfferent alternatve constructons of nformed opton tradng measures. 17

19 V. Evdence from target frms In prevous sectons, we have documented that opton tradng contans nformaton on M&A acqurer CAR. To make the study more comprehensve, we also consder a smaller sample of target frms, and fnd some supportng evdence for our man hypothess. We follow the same sample selecton procedure as that for acqurers, and obtan 2,372 M&A observatons (1,990 target frms) durng January 1996 to December The summary statstcs are shown n Table Appendx 1. Most target frms have postve announcement returns. The mean return s 16.62%, whch s much hgher than that of acqurers. Investors regard the M&A events as good news for target frms and are expectng postve returns after the mergers or acqustons. In addton, events wth cash-only payment have a hgher mean return than those wth shares payment method. The dfference s about 10%. Table Appendx 2 reports summary statstcs of IV spread and IV skew for targets. Dfferent from acqurers, targets have a slghtly postve mean for IV spread, suggestng that call opton s more expensve than put opton for the matchng par. It ndcates a hgher demand for call optons due to nvestors expectaton that target frms wll have postve returns n near future. To examne the general pattern of target CARs wth respect to our nformed opton tradng measures, we repeat the analyss n Table 3 by sortng the sample nto quntles based on preevent IV spread and IV skew (Table Appendx 3). Each quntle has a sgnfcantly postve mean return from day t to t+1. In general, t s consstent wth the fndng n acqurers that target CAR ncreases wth IV spread and decreases wth IV skew. [Table 9 about here] Our hypothess s that opton traders hold prvate nformaton on M&A events. Target announcement return can be postvely predcted by IV spread and negatvely predcted by IV skew. We rerun our man regresson n equaton (3), usng target CAR from day t to t+1 as dependent varable, and target IV spread and IV skew on day t-1 as ndependent varables separately. All control varables follow the same defntons as before, except that we use target nformaton for pre-month and pre-year return and frm characterstcs. Table 9 shows the crosssectonal regresson results. IV spread has a postve predcton by tself (β 1 = 4.66) and wth all controls (β 1 = 2.42). IV skew has a negatve and sgnfcant predcton by tself (β 1 = ) and 18

20 wth all controls (β 1 = ). In general, we fnd some supportng evdence n target frms, whch s consstent wth Cao, Chen, and Grffn (2005). VI. Concluson It has been documented that opton tradng contans nformaton on future stock returns. Some lterature has studed tme-seres and cross-sectonal predctons of opton tradng. Others employ opton measures n corporate event studes such as earnngs announcements and stock splts. However, lttle s known about the nformatonal content of opton tradng pror to M&A events. Our paper, to our knowledge, s the frst one to study the predctablty of opton tradng on M&A acqurer announcement return. Investors tend to captalze on ther prvate nformaton, and trade actvely to take advantage of the hgh lqudty and leverage of optons. We thus hypothesze that pre-event opton tradng contans nformaton on M&A acqurer announcement return. We adopt two newly-developed proxes for nformed opton tradng. A larger IV spread ndcates a hgher demand for calls and a postve expectaton on future stock returns. We fnd that IV spread postvely predcts M&A acqurer announcement return. On the other hand, a larger IV skew s a proxy for a hgher buyng pressure on OTM put relatve to ATM call, ndcatng that nvestors are expectng a negatve return n future. Thus IV skew should negatvely predct M&A acqurer announcement return, as confrmed by our man results. We further support our man hypothess by consderng the followng three aspects. Frst, we fnd that predctablty of opton measures s hgher f opton has a relatvely hgher lqudty and stock has a relatvely lower lqudty pror to M&A announcement. On the other hand, f opton s less lqud, whle stock s relatvely more lqud, the predctablty wll be lower. Second, we provde evdence that pre-announcement nformed opton tradng s also related to acqurer longrun equty performance. Adoptng calendar-tme portfolo regresson, we fnd that acqurers wth hgher pre-announcement IV spread and lower pre-announcement IV skew exhbt hgher abnormal returns n one-year to fve-year horzon followng M&A announcements. Besde, IV spread and IV skew also predct post-m&a BHAR and quarterly earnngs announcement CAR. Thrd, we adopt a volume-based proxy for nformed opton tradng, and fnd that a hgher O/S s 19

21 assocated wth a hgher absolute announcement return for acqurer. If nformaton has been partally ncorporated nto pre-event stock prces, the announcement absolute CAR wll be smaller, and the predctve power of O/S wll decrease. It suggests that at least some nvestors have correctly predcted the drecton of prce changes around M&A announcements. Moreover, our man results are robust usng other varatons of IV spread and IV skew, such as the ranks, change from prevous week, and change from prevous month. The results are not domnated by events wth small deal values or frms wth small market captalzatons. To sum up, the M&A acqurer announcement return can be predcted by pre-event nformed opton tradng measures. The predctve power s strengthened f opton s relatvely more lqud than stock. Informed opton tradng can also predct acqurer long-run performance. Our man results hold for a smaller sample of target frms that IV spread and IV skew show some predctablty on target announcement return. 20

22 Appendx: Constructon of mpled volatlty spread and mpled volatlty skew A. Impled volatlty spread We employ mpled volatlty (IV) spread documented n Cremers and Wenbaum (2010) as one of our proxes for nformed opton tradng actvty. To measure devatons from put-call party, IV spread s constructed as the average dfference n mpled volatltes between call and put optons for the same securty wth the same strke prce and the same maturty. In partcular, we compute the IV spread for each frm on each day t as IV Spread N, t calls puts, t IV, t IV, t j 1 w j, t ( IV call j, t IV put j, t ) (1) where j refers to pars of call and put optons wth the same strke prce and the same maturty, N t s the total number of vald pars for each stock on day t, and w, s the weght where we use t j the average open nterest of call and put n each par. IV, represents the Black-Scholes (1973) j t mpled volatlty for each call and put opton. We exclude those optons wth zero open nterest or zero best bd prce. We only keep short-term optons wth tme-to-maturty less than 60 days, because an opton wth ts maturty longer than two months s less lqud. If nvestors have prvate nformaton on M&A events, they are more lkely to trade on short-term optons so as to realze proft mmedately. Short-term optons are thus expected to reflect more on the nformaton embedded n pre-event opton tradng. B. Impled volatlty skew The other opton measure we adopt s mpled volatlty (IV) skew. Accordng to Xng, Zhang, and Zhao (2010), we calculate IV skew for frm on day t, as the mpled volatlty dfference between out-of-the-money (OTM) put and at-the-money (ATM) call, IV Skew t IV OTMput t IV ATMcall t (2) Where IV t represents the Black-Scholes (1973) mpled volatlty for OTM put and ATM call opton. To ensure opton lqudty, we also use short-term optons wth tme-to-expraton between 10 to 60 days. We requre stock volume and opton volume to be postve to elmnate 21

23 those non-tradng cases. We further restrct stock prce to be greater than $5, opton open nterest to be postve, mpled volatlty of optons to be between 3% and 200%, and opton s average bd and ask prce to be hgher than $ We defne moneyness as the rato of strke prce to stock prce. OTM puts are defned as put optons wth moneyness between 0.80 and 0.95, whle ATM calls are defned as call optons wth moneyness between 0.95 and If there are multple OTM puts and ATM calls, we select one OTM put wth moneyness closest to 0.95 and one ATM call wth moneyness closest to 1. In several occasons, there are put optons wth the same moneyness whch s closest to We keep the one wth the hghest open nterest, or f open nterests are the same, we keep the one wth the hghest stock tradng volume. We follow the same selecton crtera for ATM calls. In ths approach, we come up wth one skew measure for each frm on each day t. 22

24 References Amhud, Yakov, 2002, Illqudty and Stock Returns: Cross-Secton and Tme Seres Effects, Journal of Fnancal Markets 5, Bal Turan G. and. Hovakman, Armen, 2009, Volatlty Spreads and Expected Stock Returns, Management Scence, 55(11), Bester, C. Alan, Martnez, Vctor H., and Rosu, Ioand, 2011, Opton Prces and the Probablty of Success of Cash Mergers, Workng paper. Black, Fscher, and Scholes, Myron, 1973, The Prcng of Optons and Corporate Labltes, Journal of Poltcal Economy, 81(3), Boehmer, Ekkehart, Jones, Charles M., and Zhang Xaoyan, 2011, What Do Short Sellers Know? Workng paper. Bollen, Ncolas, and Whaley, Robert, 2004, Does Net Buyng Pressure Affect the Shape of Impled Volatlty Functons? Journal of Fnance, Amercan Fnance Assocaton, 59(2), Cao, Charles, Chen, Zhwu, and Grffn, John, 2005, Informatonal Content of Opton Volume Pror to Takeovers, Journal of Busness, 78, Carhart, Mark M., 1997, On Persstence n Mutual Fund Performance. Journal of Fnance, Amercan Fnance Assocaton, 52(1), Chan, Konan, L Fengfe and Ln, Tse-Chun, 2012, Informed Tradng and Stock Splts, Workng paper. Cremers, Martjn and Wenbaum, Davd, 2010, Devatons from Put-Call Party and Stock Return Predctablty, Journal of Fnancal and Quanttatve Analyss, 45(2), Dens. Davd J. and Sarn, Atulya, 2001, Is the Market Surprsed by Poor Earnngs Realzatons Followng Seasoned Equty Offerngs? Journal of Fnancal and Quanttatve Analyss, 36(2), Dressen, Joost, Ln, Tse-Chun, and Lu, Xaolong, 2012, Why Do Opton Prces Predct Stock Returns? Workng paper. 23

25 Easley, Davd, O'Hara, Maureen, and Srnvas P.S., 1998, Opton Volume and Stock Prces: Evdence on Where Informed Traders Trade, Journal of Fnance, Amercan Fnance Assocaton, 53(2), , 04. Fama, Eugene F., 1998, Market Effcency, Long-term Returns, and Behavoral Fnance, Journal of Fnancal Economcs, 49, Harford, Jarrad, Jenter, Drk, and L Ka 2011, Insttutonal Cross-holdngs and Ther Effect on Acquston Decsons, Journal of Fnancal Economcs, 99(1), Ikenberry, Davd L., and Ramnath, Sundaresh, 2002, Underreacton to Self-selected News Events: the Case of Stock Splts, Revew of Fnancal Studes, 15, Jn, Wen, Lvnat, Joshua, and Zhang, Yuan, 2012, Opton Prces Leadng Equty Prces: Do Opton Traders Have an Informaton Advantage? Journal of Accountng Research, Forthcomng. Johnson, Travs L. and So, Erc C., 2011, The Opton to Stock Volume Rato and Future Returns, Journal of Fnancal Economcs, Forthcomng. Lee, Charles, and Ready, Mark, 1991, Inferrng Trade Drecton from Intraday data, Journal of Fnance, Amercan Fnance Assocaton, 46, Loughran, Tm and Vjh, Anand M., 1997, Do Long-Term Shareholders Beneft From Corporate Acqustons? Journal of Fnance, Amercan Fnance Assocaton, 52 (5), Moeller, Sara B., Schlngemann Frederk P., and Stulz, René M., 2004, Frm Sze and the Gans from Acqustons, Journal of Fnancal Economcs, 73(2), Moeller, Sara B., Schlngemann, Frederk P., and Stulz, René M., 2005, Wealth Destructon on a Massve Scale: A Study of Acqurng Frm Returns n the Merger Wave of the Late 1990s, Journal of Fnance, Amercan Fnance Assocaton, 60(2), Netter, Jeffry M., Stegemoller, Mke A., and Wntok M. Babajde, 2011, Implcatons of Data Screens on Merger and Acquston Analyss: A Large Sample Study of Mergers and Acqustons from , Revew of Fnancal Studes, 24 (7), Newey, Whtney K., West, Kenneth D., 1987, A Smple, Postve Sem-defnte, Heteroskedastcty and Autocorrelaton Consstent Covarance Matrx, Econometrca, 55(3),

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