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2010 http://www.eurojournals.com/finance.htm

**Working Capital Management in Indian Tyre Industry
**

Jasmine Kaur Assistant Professor in Guru Arjan Dev Institute of Management & Technology, New Delhi E-mail: jasmine.rus@gmail.com Tel: (91) 9811160007; (91)9811669777; (91) (011) 25133012 Abstract The management of Working Capital is one of the most important and challenging aspect of the overall financial management. Merely more effective and efficient management of working capital can ensure survival of a business enterprise. Working Capital Management is concerned with the problems that arise in attempting to manage the Current Assets, Current Liabilities and the interrelation that exists between them. This is a two-dimensional study which examines the policy and practices of cash management, evaluate the principles, procedures and techniques of Investment Management, Receivable and Payable Management deals with analyzing the trend of working capital management and also to suggest an audit program to facilitate proper working capital management in Indian Tyre Industry. The study covers a production of 8 year viz, 1999-2007. For the purpose of investigation both primary and secondary data is used. The collected data is analyzed by applying research tool which include accounting tools like Analysis, Cash Flow Analysis, Common Size and Trend Analysis. They reveal that there is a stand off between liquidity and profitability and the selected corporate has been achieving a trade off between risk and return. Efficient management of working Capital and its components have a direct effect on the profitability levels of tyre industry. Keywords: Working Capital Management, Cash Management, Inventory Management, Receivables and Payables Management, Indian Tyre Industry.

Introduction

Working Capital Management refers to all management decisions and actions that ordinarily influence the size and effectiveness of the working capital. It is concerned with the most effective choice of working capital sources and the determination of appropriate levels of the current assets and their use. It focuses attention to the managing of current assets, current liabilities and the relationships that exist between them. In the present day of rising capital cost and scarce funds, the importance of working capital needs special emphasis. It has been widely accepted that the profitability of a business concern likely depends upon the manner in which its working capital is managed. The inefficient management of working capital not only reduces profitability but ultimately may also lead a concern to financial crises. On the other hand, proper management of working capital leads to a material savings and ensures financial returns at the optimum level even on the minimum level of capital employed. Both excessive and inadequate working capital is harmful for a firm. Excessive working capital leads to unremunerative use of scarce funds. On the other hand, inadequate working capital usually interrupts the normal operations of a business and impairs profitability. There are many instances of business failure for inadequate working capital e.g. Modi Rubbers. Further, working capital has to play a vital role to

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International Research Journal of Finance and Economics - Issue 46 (2010)

keep pace with the scientific and technological developments that are taking place in the area of tyre industry. Also, the current financial parameters of tyre industry are much less than the desired level. In this context, an attempt has, therefore, been made to undertake an indepth study on working capital management of Indian Tyre Industry.

**Objectives of the Study
**

The primary aim of our study is to examine and assess management of working capital of selected companies of Indian Tyre industry i.e. JK, MRF, Apollo, Ceat. In this broader framework an attempt will be made to meet out the following specific objectives of the study:1. To study the components of Working Capital Management in Indian tyre Industry 2. To assess at length, prevalent practices of inventory management, cash management and receivables management on the profitability and liquidity of firms in the Tyre Industry. 3. To analyse the relative proportion of different sources of finance for working capital of Indian Tyre industry.

Research Design

The present study is focused on understanding the impact of efficient working capital management on the profitability and liquidity of the companies. Hence, it’s a case of purposive sampling requiring an in-depth analysis of each selected company. This has led to selection of four companies representing India Tyre Industry, namely MRF Ltd., Apollo Tyres Ltd., J.K. Tyres Ltd. and Ceat Ltd. The study covers a period of 8 years (1999-2000 – 2006-2007) and the data is collected from primary and secondary sources. The data so collected is analyzed by applying various research tools which include accounting tools like Ratio Analysis, Cash Flow Analysis, Common Size and Trend Analysis. Key Observations and Findings The following are the major observations and findings of the study w.r.t each component of the working capital of the sample companies:

Inventory Management (a)

• Inventory Turnover ratio signifies the amount of sale generated with each unit invested in raw material. The inventory utilization by J.K. and Ceat is quite effective but Apollo and MRF need to take measures to increase to stock turnover. This is possible only by shortening the operating cycle in days taken from the point of purchase of raw material to its conversion to the final sale to the consumers and the money getting back into the organization to be utilized again by the company to purchase raw materials for the next operating cycle.

Exhibit 1:

Year 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Apollo 3.82 5.30 6.12 5.75 5.67 5.29 5.75 J.K. 3.86 7.17 -7.54 7.62 7 5.5 Ceat 3.83 4.34 5.76 6.16 7 7 8.76 MRF 3.23 2.94 3.67 3.92 4.25 4.69 5.9

K. This can be done by avoiding stocking up of raw materials.tyres has already started taking the initiative to reduce the number of holding days from 61 days to 30 days. .K.K . 33 61 -57 54 34 30 Ceat -21 14 23 26 10 15 MRF 22 27 25 25 21 25 25 Comparative Raw Material holding day 70 60 50 40 30 20 10 0 200001 200102 200203 200304 200405 200506 200607 Apollo J. The finished goods holding period of Ceat is very less of 12 days as compared to Apollo. Exhibit 2: Comparative Raw Material holding days of Apollo. Tyres have to reduce the number of holding days.K. The raw material holding period of Ceat is quite reasonable but Apollo and J. Reducing the number of holding days whether raw materials or finished goods is important as this will shorten the operating cycle which would increase the working capital turnover indicating its efficient use. J. Ceat MRF • The raw material holding period identifies the number of days the raw material stays in the company before being put into the production process.Issue 46 (2010) 9 Comparative Inventory Turnover Ratio 10 9 8 7 6 5 4 3 2 1 0 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Apollo J. Ceat and MRF (in days) Year 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Apollo 34 27 30 32 38 38 30 J.K.International Research Journal of Finance and Economics . and MRF which is around 18-20 days. Ceat MRF • • • J.K. J.K.

89 16.45 8.K.06 6. 28 15 -12 10 17 18 Ceat -23 20 18 12 11 12 MRF 36 37 32 30 29 23 20 Comparative finished goods holdiong period 40 35 30 25 20 15 10 5 0 2000. Ceat MRF • MRF has the highest inventory to current assets ratio of around 50%.97 4.63 5.52 7.K.25 9. Exhibit 4: Comparative Debtors Turnover Ratio of Apollo.69 19 18 20 J.52 6.46 5.98 8.2001.37 6.65 22.73 8.K.2004. J. J.10 International Research Journal of Finance and Economics .K.63 6 Ceat -6.75 7. This means that a lot of money of MRF is blocked in excess inventory storage which should be reduced.04 7.2 8 7.74 7.200601 02 03 04 05 06 07 Apollo J.08 .59 7.2003. Receivables Management (b) • Receivables management indicates management’s efficiency in getting the money back into the organization in the shortest period of time.K.2002. The debtors turnover ratio reflects the number of times the money received from debtors is rotated in the business cycle in a year. Ceat and MRF (in times) Year 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Apollo -9. Ceat and MRF (in times) Year 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Apollo 25 19 12 15 14 17 18 J.2005. The Debtors Turnover Ratio of Apollo is the best indicating the management’s efficiency in getting the money back from the debtors and again rotating it in the business to generate sales.68 MRF -6 6. 7.Issue 46 (2010) Exhibit 3: Comparative Finished goods holding period of Apollo.

Exhibit 5: Comparative Average Collection Period of Apollo. J.. Ceat and MRF (in days) Year 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Apollo -39 36 22 16 19 20 18 J. The average payment period of MRF is very short which is almost equivalent to its average collection period.K. . 51 53 43 -64 65 54 60 Ceat 55 60 50 45 47 47 45 77 MRF -60 57 53 48 46 43 45 Comparative Average Collection Period 90 80 70 60 50 40 30 20 10 0 1999. Ceat MRF 200001 200102 200203 200304 200405 200506 200607 • J.K.K.International Research Journal of Finance and Economics . Ceat and MRF should take stringent steps to get the money back into the organization quickly by reducing the average collection period.K. Ceat MRF • • The Debtors Turnover Ratio of Apollo is very high which is quite appreciable. MRF should increase the payment period unless and until early payment helps in getting heavy cash discounts.K.2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2000 Apollo J. This is due to the fact that the average collection period of Apollo is very short of around an average of 24 days as compared to others ranging from 50 to 55 days.Issue 46 (2010) Comparative Debtors Turnover Ratio 11 25 20 15 10 5 0 19992000 Apollo J.

and MRF (crores) Year 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Apollo 44.28 66.12 International Research Journal of Finance and Economics .43 231.39 40. Apollo needs to look into its cash management system and bring some changes as there seems to be unnecessary idle cash lying in the business which could otherwise be used more productively.K. Ceat already has started with remedial measures of utilizing excess cash into suitable ventures.23 36.15 38. Exhibit 7: Comparative Cash Balance of Apollo.89 31.K. Ceat and MRF (in days) Year 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 Apollo -131 141 100 82 82 78 81 J.42 66.88 • • .K.35 110.23 39.02 53.88 34.Issue 46 (2010) Exhibit 6: Comparative Average Payment period of Apollo.32 72.K.16 39.11 39. J.61 106. 148 156 96 -129 114 97 90 Ceat -90 97 141 143 147 125 111 MRF -77 80 67 57 52 51 48 Comparative Average Payment Period 180 160 140 120 100 80 60 40 20 0 19992000 200001 200102 200203 200304 200405 200506 200607 Apollo J. 18.K.36 172 J. Ceat MRF Cash Management (c) • Cash management throws light on the judicious and efficient use of cash (which is the most liquid asset of an organization).92 MRF -34.07 -38.87 Ceat 71. seems to have the best cash management system since it is the policy of management to invest excess cash into profitable investment avenues.26 36.88 55.34 97.83 56.89 64.72 46.61 34. J. J. Ceat.32 23.K.18 46.

2002. The company needs to utilize the excess cash and bring down the percentage.K. there has been a sudden decline in quick ratio in the year 2005-2006 and 2006-2007. the net profit ratio has also improved .2001.International Research Journal of Finance and Economics .2004. as incase of MRF where liquidity levels are very high as compared to the industry standards but profitability levels do not rise upto expectations even though MRF has the largest market share.No definitive approach MRF . These two don’t go hand in hand. On an average. There is an inverse relationship between the two as analysed from financial reports.K. and Ceat the current ratio is less than two which reflects a poor liquidity position of these two enterprises. the net working capital is largest in MRF followed by Apollo. Higher the liquidity levels. it is revealed that the former are insufficient to cover current liabilities in case of J.K. • When quick assets are compared with current liabilities. lower would be the profitability and vice-versa. For Ceat Ltd.2003. tyre companies have to maintain a delicate balance between the two.Issue 46 (2010) Comparative Cash Balance 250 200 150 100 50 0 1999.20062000 01 02 03 04 05 06 07 Apollo J. Key Observations and Summary The major observations of the study are as follows:• The selected sample companies have been following either an aggressive or a conservative approach: APOLLO .2005.K.Conservative approach • All the companies have a positive net working capital except in the case of Ceat Ltd. therefore. • There is a stand off between liquidity and profitability position of the tyre companies.2000. This will also help the company to increase its profitability.K .10%.Aggressive approach CEAT . MRF and Apollo are in good position to pay off current debts from quick assets. • If standard current ratio is to be taken as 2:1 then Apollo and MRF have current ratios equal to or more than two. and Ceat. • The efficient management of Working Capital and its components have a direct effect on the profitability levels of the tyre companies:o With increase in working capital turnover of Apollo and MRF. But incase of J. J. Tyres. Ceat MRF 13 • The percentage of cash out of total current assets of Apollo is very high ranging from 15% 20% as compared to others ranging from 2% .Aggressive approach J. in 20052006 and 2006-2007.

Ceat and MRF is apparent from their low DTR and further low profitability levels. The study of the turnover ratios compiled over a period of 8 years show that there has been an improvement in utilization of current assets. the share of cash has declined except incase of MRF.Issue 46 (2010) o An efficient receivables management by Apollo has led to short operating cycle which has led to high debtor turnover ratio and high profitability levels of the company. Over a period of time. IFCI. there is a gradual decline in the liquidity level and the company should be aware of a liquidity crises coming up. much above the industry level. . it shows no effect on the profitability levels. has the highest working capital turnover ratio.. the share of inventories in total assets. o Loans from financial Institutions like IDBI. This may be due to over-trading which the company should look into as early as possible. • Although J.K. Since inventories occupy a major share in current assets and its share has increased over a period of time. the tyre companies generally prefer: o Bank overdraft/Bank cash credit for immediate solution.K. o Short term loans from Banks generally secured by hypothecation of Inventories and book debts. • For financing any working capital requirements. • The tyre companies have on an average half of their total assets in the form of current assets. The results reveal that there is a standoff between liquidity and profitability and the selected corporate has been achieving a tradeoff between risk and return. on an average. ICICI by hypothecation of immovable properties. High collection period from debtors of J.K. Also.14 International Research Journal of Finance and Economics . The average ratio of current assets to total assets is largest for MRF followed by Ceat. Apollo and J. The increasing share of inventories indicates that current assets seem to have become less liquid. Conclusion The present study reflects that the proper management does affect positively on the profitability levels of the sample companies. Of the total different components of current assets. The companies over the years have realized the importance of efficient working capital management and have worked in bringing about a productive change in WCM techniques. is largest followed by receivables and cash. the tyre industry should pay more attention to management of inventories.

Pointer Publishers. Richard D. (2002). Agarwal N. New Delhi: Sultan Chand & sons. Bhalla. Readings in Financial Management Jaipur: Rupa Publishers. Gupta M. London: McDonald and events Ltd.P.com http://www. New Delhi.org www.C. L.P. (1987).International Research Journal of Finance and Economics . Delhi.N. Inventory Management in India .Issue 46 (2010) 15 References Books [1] [2] [3] [4] [5] [6] [7] Anthony. Khosla Publishing House.K.ICAI.S. and Mangal S. Horward.com www. Irwin Inc. Mumbai:Allied Publication. Financial Management. V.(1998).(1988).mrftyres. Management Accounting Taxes and cases Illinois. The Indian Accounting journal and Finance The Accounting Review Websites [1] [2] [3] [4] [5] www. Working Capital: Its Management and control. R. Chaddha R. (1989). Jaipur . Statistical Methods.K.al. et.apollotyres..jktyres.com www. Gupta. Periodicals/Journals/Bulletins [1] [2] [3] The Journal of Industries and Trade Lok Udyog. (2002).ceatyres. Profitability Analysis. (1987).R. Reports/Official Publications [1] Annual reports of selected Companies of the selected period.. S.com/ .

Inc. For firms with higher leverage. Taichung 402. Risk-Neutral Kurtosis. While examining the firm-specific and market-wide factors explaining the implied volatility smile. the more negative skewness of the FTSE 100 index options. and the greater the risk-neutral kurtosis. Kuo Kuang Rd. the flatter the slope of the smile. Investigation of the influence of firm-specific variables on the slope of implied volatility of individual stock options indicates that for firms whose stock return is more volatile the slope of the smile is less negative. Taiwan E-mail: changij@webmail. Gram-Charlier Series Expansion.nchu. Leverage Effect JEL Classification Codes: G12. and incorporates non-normal skewness and kurtosis terms in the adjusted option price. 321. Risk-Neutral Skewness. and larger traded volume the smile tends to have a more negative slope. With regard to endogenous variables.edu. the steeper (more negative) the slope of the smile will be. Keywords: Implied Volatility Skew. National Taipei College of Business No. larger beta. There are few investigations detailing the characteristics of the implied volatility smile or implied volatility skew available in the literature. one can detect at the same time the influence of these variables in the pricing of stock options.tw Bing-Huei Lin Department of Finance. Section 1. G13 1.eurojournals.edu.tw Abstract The aim of this study is to examine the firm-specific and market-wide factors explaining the implied volatility skew in LIFFE equity options.ntcb. National Chung Hsing University No. of larger size. 2010 http://www. Taiwan E-mail: linbh@dragon. the more negative the risk-neutral skewness. . and the greater the kurtosis of the FTSE 100 index options. we also estimate the risk-neutral moments by numerically solving the nonlinear leastsquares problem. Risk-Neutral Distribution.htm Determinants of the Implied Volatility Skew in LIFFE Equity Options Ing-Jye Chang Department of Business Administration. 500. Jinan Rd. Taipei 100. the flatter the slope of the smile for individual stock options.International Research Journal of Finance and Economics ISSN 1450-2887 Issue 46 (2010) © EuroJournals Publishing. Introduction This article investigates the determinants of the implied volatility skew (smile) using the prices of individual stock options traded on the LIFFE (London International Financial Futures and Options Exchange). Our theoretical model uses Gram-Charlier series expansion to approximate the distribution of the logarithm of stock prices.com/finance. and therefore the results of this study should be useful for implementation. the steeper the slope of the smile is for individual stock options. greater volatility in the market is associated with a smile of steeper slope. For the market-wide variables.

the more negative the skewness of the FTSE 100 index option. In Section 2. they also show that the use of an options pricing model with higher order moments and time-varying volatility improves performance and corrects the volatility skew. and Rockinger (2001) compare the mixture of log-normal densities method. and the greater the kurtosis of the FTSE 100 index option. Hermite expansion method.Issue 46 (2010) Two classification methods. and maximum entropy method of extracting the risk-neutral distribution implied in PIBOR interest rate future options. unlike the option implied risk-neutral skewness. are used to extract the risk-neutral distribution from option prices. In this article we use Gram-Charlier series expansion to approximate the distribution of the logarithm of stock price.S. which can present the change of the implied volatility skew better than the skewness. . The variable slope of the volatility smile can be observed directly. with less bias in market price. In the examination of the influence of market-wide variables on the slope of implied volatility of individual stocks. Other articles such as that of Pena. For example. and Corrado and Su (1996) use Gram-Charlier series expansion of the normal probability density function to model the distribution of the logarithm of stock price to provide skewness and kurtosis adjustment terms for the Black and Scholes option formula. In Section 4. A summary and conclusion are given in Section 5. A criterion documented by Jackwerth (2004) is that a fast and stable method should be chosen to extract the risk-neutral distribution. the flatter the slope of the smile. Previous articles have used series expansion in modeling the option prices. Rubio. The put-to-call traded volume ratio is not significantly related to the slope of the smile except the medium-term option data. larger beta. the steeper (more negative) the slope of the smile. In addition. the greater the degree of risk-neutral kurtosis. Jondeau. we describe the option data used in this study as the empirical sample and construct the risk-neutral moments implied in option prices. Treasury market. we conduct the regression and robustness tests. we describe the construction of dependent and independent variables. and in general. and Aijo (2005) also use the Gram-Charlier expansion model in pricing bond future options. in addition. but he indicates that the choice of a particular method does not significantly alter the results. parametric and nonparametric. the steeper the slope of the smile of individual stock options. Tamaki and Taniguchi (2006) provide evidence that option prices are strongly affected by the non-Gaussianity and dependency of stock log returns when incorporated into the model. and larger traded volume tend to have a smile of more negative slope. Vahamaa. In this study. their results indicate that the implied volatility across methods is of a similar magnitude and the riskneutral skewness and kurtosis are of differing magnitudes but have similar variation patterns for a given date. Lim. meaning that when the stock index return is of larger volatility and is accompanied by larger volatility of individual stocks return. we use the slope of the implied volatility curve as a dependent variable. Navatte and Villa (2000) provide evidence that the option price model derived using the Gram-Charlier density is more accurate than the Black and Scholes option formula. The following articles document the improved model for pricing options. They also indicate that it is difficult to select the best method among these methods.17 International Research Journal of Finance and Economics . and Serna (1999) employ Spanish IBEX-35 index options to examine the transaction costs and market condition variables in order to explain the pattern of the implied volatility curve. and Beber and Brandt (2006) use the skewness-kurtosis-adjusted Black (1976) formula to examine the effect of regularly-scheduled macroeconomic announcements on the beliefs and preferences of participants in the U. Jarrow and Rudd (1982) use Edgeworth series expansion to approximate the lognormal distribution of stock price. the flatter the slope of the smile of individual stock options. Watzka. Our results indicate that firms with a larger volatility of stock return have a smile of less negative slope. which is used in the alternative approach. and incorporate non-normal skewness and kurtosis terms in the adjusted option price to expand the Merton (1973) option price formula. of larger size. and firms with higher leverage. Coutant. The rest of this article is organized as follows. the Gram-Charlier-approximated estimated FTSE 100 index option implied volatility is negatively related to the slope of the smile of individual stocks. In Section 3. the more negative the risk-neutral skewness. and Martin (2005) indicate that misspecifications for pricing options are due to the occurrence of volatility smile and skew. Martin. For the endogenous variables.

τ . the option is grouped in the long-term category. incorporating non-normal skewness and kurtosis terms in the pricing of the European-style FTSE 100 index option. γ 2 n in the expanded Merton (1973) European-style option prices by numerically solving the following nonlinear least-squares (NLLS) object function: . θ t is annualized dividend yield.τ . Data and Construction of Risk-Neutral Moments 2. ϕ (⋅) is the standard normal density. d = [ln(S t / K ) + (rtτ − θ t + σ 2 / 2)τ ] / σ τ .International Research Journal of Finance and Economics . K = Ke − rtτ τ N (− d + σ τ ) − S t e −θ tτ N (− d ) are the formulae of Black and Scholes (1973). and if the remaining time to expiration is over 240 days. and long-term data to run the regression models in order to examine the firm-specific and market-wide variables explaining the implied volatility skew (smile). rtτ is the continuously compounded τ period interest rate. The 3-month Treasury-bill rate is used as the proxy for the risk-free interest rate. 2. γ 1n . which is also obtained from the DataStream database. options with a remaining time to expiration of less than 9 days were discarded.τ . adapted so as to consider the dividend payment stock call and put options by Merton (1973). 1992 through December 31. K ≈ Pt . and N (⋅) is the standard normal cumulative distribution function. The primary options data are obtained from the LIFFE database. Although options with longer-term maturity are illiquid compared with short-term options. K (1 + γ 1n 3! σ τ3 + γ 2n 4! σ τ4 ) + γ 1n 3! e − rtτ τ [σ τ Kϕ (σ τ − d )(2σ τ − d ) + σ τ3 KN (d − σ τ )] + + σ τ4 KN (d − σ τ )] γ 2n 4! e − rtτ τ [σ τ Kϕ (σ τ − d )(3σ τ2 − 3dσ τ − 1 + d 2 ) (1) Pt *τ . and Wu (1997).τ . and Beber and Brandt (2006).2. K is the option strike price. K ≈ Ct .1. and the corresponding stock prices and index data are obtained from the DataStream database. medium-term. Foresi. and dividend yield are obtained from the DataStream database. we decided to incorporate them in this study to increase the degrees of freedom. the individual stock’s market value.Issue 46 (2010) 18 2. it is grouped in the short-term option category. We group the sample options into three categories in order to examine the analysis across maturities: if an option has a remaining time to expiration of between 9 and 120 days. Option Pricing with Gram-Charlier Density As described by Backus.τ . The Data In this study we use daily settlement prices for 79 individual stock options and the FTSE 100 index option (ESX) traded on the LIFFE as our research samples. the option is grouped in the medium-term category. we then derive the expanded Merton (1973) option price model as equations (1) and (2). the Gram-Charlier series expansion is used to derive the risk-neutral density of the logarithm of the underlying price. K = St e −θ tτ N (d ) − Ke − rtτ τ N (d − σ τ ) and Pt . Ct*. respectively. γ 1n and γ 2 n are the skewness and excess kurtosis coefficients of stock index return. We estimate the three parameters σ τ . the individual stock options are American-style. The underlying stocks are traded on the London Stock Exchange (LSE). γ 1n 3! σ τ3 + γ 2n 4! σ τ4 ) − γ 1n 3! e − rtτ τ [σ τ Kϕ (σ τ − d )(−2σ τ + d ) (2) + σ τ3 KN (−d + σ τ )] + − σ τ4 KN (−d + σ τ )] γ 2n 4! e − rtτ τ [−σ τ Kϕ (σ τ − d )(−3σ τ2 + 3dσ τ + 1 − d 2 ) where Ct . K (1 + . traded volume. if the remaining time to expiration falls between 121 and 240 days. The overall sample period extends from March 13. We then use the short-term. while the FTSE 100 index option is European. As very short maturity stock option quotes may not be active. 2002. Li.

γ 1n 3! σ τ3 + γ 2n γ 2n 4! σ τ4 ) − γ 1n 3! e (θt −rtτ )τ [σ τ K 'ϕ(σ τ − d ' )(−2σ τ + d ' ) 2 4! 4 ' ' − σ τ K N (−d + σ τ )]}+ (1 − λtP.K (4) t t τ Pt*τ*. The expanded American call and put option prices for the individual stocks can be defined as the weighted average of the upper and lower bounds of the call and put options.τ Ptuτ . the expanded American put option price is Pt*τ*. respectively.τ .τ .K + (1− λC. as shown in equations (6) and (8). (5) For the upper bounds of American calls on dividend paying stocks we use the non-randomized version of the method of Chung and Chang (2007). C tu.* . and the Melick and Thomas (1997) version otherwise. K ) t When the interest rate is smaller than the dividend yield. K ) t e (θt −rtτ )τ [σ τ K 'ϕ(σ τ − d ' )(3σ τ3 − 3d 'σ τ −1 + d ' ) (9) where K ' = e − (θ t − rtτ )τ K and d ' = [ln(S t / K ' ) + (rtτ − θ t + σ 2 / 2)τ ] / σ τ . K ≈ λC. Ki (⋅)]2 + [ Pt .τ ) max(S t − K .τ .K + (1 − λtP.K . K ' (1 + τ t γ 1n 3! σ τ3 + γ 2n 4! σ τ4 ) + γ 1n 3! e (θt −rtτ )τ [σ τ K 'ϕ (σ τ − d ' )(2σ τ − d ' ) 2 + σ τ3 K ' N (d ' − σ τ )] + γ 2n 4! 4 ' ' + σ τ K N (d − σ τ )]}+ (1 − λC. e − (θ t − rtτ )τ K − S t +τ )] (10) . . Ki − Ct*. Pt uτ . 1n .τ {eθtτ Ct . C tu.*. Ct*. K = e (θ t − rtτ )τ Et [max(0. respectively.τ .τ {eθtτ Pt .Issue 46 (2010) min ∑∑ {[C τ σ γ γ τ N M . K j (⋅)]2 } . + σ τ3 K ' N (−d ' + σ τ )] + e (θt −rtτ )τ [−σ τ K 'ϕ(σ τ − d ' )(−3σ τ3 + 3d 'σ τ + 1 − d ' ) (11) .τ .τ .τ .K = λtP.τ . and the interest rate is only of slightly less magnitude than the dividend yield on average.τ . K = e (θ t − rtτ )τ Et [max(0. (3) where the option prices Ct .τ . K ≈ λtP. For the upper bounds of American puts on dividend paying stocks.τ . we use the non-randomized version of the method of Chen and Yeh (2002) while the interest rate is greater than the dividend yield. .* .K ) . K j − Pt *τ . K (1 + t τ γ 1n 3! σ τ3 + γ 2n 4! σ τ4 ) + γ 1n 3! e (θt − rtτ )τ [σ τ Kϕ (σ τ − d )(2σ τ − d ) (7) 4! 4 + σ τ KN (d − σ τ )]} + (1 − λC. there is only a short horizontal in which the interest rate is less than the dividend yield for the individual stocks. When the interest rate is smaller than the dividend yield. During the sample period. K ' (1 + . Ct*.τ )Ptl. which are documented by Melick and Thomas (1997). K i and Pt . Ct*. When the interest rate is higher than the dividend yield.τ Ctu. Pt*τ .19 International Research Journal of Finance and Economics .τ .τ . S t +τ − e − (θt − rtτ )τ K )] the expanded American call option price is + σ τ3 KN (d − σ τ )] + γ 2n e (θt −rtτ )τ [σ τ Kϕ (σ τ − d )(3σ τ3 − 3dσ τ − 1 + d 2 ) (8) Ct*. K = e (θ t − rtτ )τ Et [max(0. When the interest rate is higher than the dividend yield. displayed in equations (4) and (5). K j in the brackets of equation (3) are the observed Europeanstyle call and put option prices. 2 n i =1 j =1 t .τ )Ctl.K = λC.τ ) max(K − S t . S t +τ − K )] (6) we can derive the expanded American call option price as Ct*.τ {eθtτ Ct .τ ) max(S t − K . K ≈ λC.τ . which are displayed in equations (10) and (12).

S t +τ − K )]) (14) Pt l. 0. K j in the brackets of equation (18) are the observed Americanstyle call and put option prices. for the short-term individual stock options. and 0. of less negative skewness. at 0.53 for the long-term options. γ 2 n . .410. In using the Gram-Charlier model to estimate the term structure of implied volatility. e − rtτ τ Et [max(0. min γ γ λ 1n . e − rtτ τ Et [max(0.τ . t 3! 4! 3! + σ τ3 KN ( − d + σ τ )] + γ 2n 4! 4 − σ τ KN ( − d + σ τ )]} + (1 − λ tP. K j − Pt*τ*. C tl.93. In other results.18. y ] ≈ log it max[ x. the decreasing phenomenon might be modified. y ]) ⋅ y (17) C P We also estimate the five parameters σ τ . K ) .τ in the expanded American-style option prices by numerically solving the following object function: στ . which guarantees positive density to solve the NLLS problem.International Research Journal of Finance and Economics . as evidenced by Beber and Brandt (2006).2049.3. K (1 + 1n σ τ3 + 2 n σ τ4 ) − 1n [σ τ K ϕ (σ τ − d )( − 2σ τ + d ) .τ . and the total average traded volume. λt . and Martin (2005) also showed that a generalized Student’s t-option pricing model can be used to correct the volatility skew. 2. we also report the averages of the 79 stocks. The weights of call and put options estimated by equation (18) here we not display in this table. -0. respectively. and kurtosis are 0. and 3. -0.Issue 46 (2010) Pt uτ . which for the FTSE 100 index option is 18. K j (⋅)]2 } τ . The results of the FTSE 100 index option implied volatility are very close. the features of the FTSE 100 index option implied skewness and kurtosis are consistent with individual stock options.43. The average implied volatility. 1 log it max[ x.τ . Martin.τ .τ {e r τ τ Pt . and 0. In Table 1 we display constrained estimates of the parameters for the short-term. 1. and 3. 20 (12) the expanded American put option price is γ γ γ Pt *τ*. The results indicate that the term structure of implied volatility turns into one that is flatter. y ] = (16) 1 + exp[−5( x − y )] max[ x.08.τ . and long-term options data. Gram-Charlier Approximated Density The problem is that using a polynomial expansion to approximate probability density may derive a negative probability. 0. Lim.τ . Equations (14) and (15) represent the maximum of the early exercise value and European-style option prices. 4].Ki − Ct*.2023.τ ) max( K − S t . -0.36. K = max( K − Et [ S t +τ ].2044 for the short-term. y ] ⋅ x + (1 − log it max[ x. and lower kurtosis for longer maturity individual stock options. C t . (18) where the option prices Ct . medium-term.11. γ 1n . we only report the results of the twenty largest stocks in the FTSE 100 index. K − S t +τ )] . Jondeau and Rockinger (2001) derive a domain in which the skewness and excess kurtosis are bounded on [-1.35. Table 1: Gram-Charlier Model-Estimated Risk-Neutral Moments . To save space. Pt *τ . K ≈ λ tP.0493] and [0.* . [ −σ τ K ϕ (σ τ − d )( − 3σ τ3 + 3 d σ τ + 1 − d 2 ) (13) For the lower bounds of American call and put options we use the version of Melick and Thomas (1997).τ ∑∑{[C τ i =1 j =1 N M t. respectively. medium-term. K = Et [max(0. The last column of Table 1 displays the average traded volume per day. respectively. skewness. respectively.0493. K i and Pt . K i (⋅)]2 + [ Pt . λtP. and long-term options. K − S t +τ )]) (15) Here we also use a logistic function to approximate the maximum operator used by Melick and Thomas (1997). 2n . λt . and 3. K = max( Et [ S t +τ ] − K .τ . which is 273 for the 79 individual stock options.τ .70 for the medium-term options.

20 4.27 -0.61 0. VOD 0.11 3.17 4. 5%].93 0.37 -0.29 986 5.06 3.12 4.65 389 13. AAM 0.28 520 17.03 3.25 -0.35 -0. Chang. 2002.39 -0. GNS 0. GXO 0.63 316 4. we show a summary of the implied volatility for all 79 individual stock options of short-term. .27 3. RTZ 0.08 3.27 3.04 3. TCO 0.70 0.21 4.94 0.87 0.85 0.04 3.18 3.25 3.35 -0.29 3. NGG 0.28 -0. Short-term options are those with a remaining time to expiration of between 9 and 120 days.24 -0.52 298 19.35 -0. The implied volatilities are average within the natural log of the moneyness and the maturity category.26 0. The entire sample period from 1992 to 2002 shows an implied volatility curve of asymmetric shape.33 -0.94 0.25 0. and Paxson (2008).91 0.73 532 10.29 -0.28 -0.37 -0.40 -0.23 -0.75 154 20. The overall sample period is from March 13.49 132 18.29 -0. AZA 0.94 0.28 -0.73 0.20 3.01 3.78 259 16.39 0. medium-term between 121 and 240 days. BBL 0.27 -0.07 3. The changing nature of the implied volatility skew of the LIFFE 79 individual stock options is shown in Figure 1.08 4.36 -0.23 3.18 3.14 3.23 0.41 -0.38 -0.33 -0.24 -0.95 0.41 0. [-5%.23 3. BP 0. TAB 0.39 -0.26 -0.31 0.14 3.36 -0.09 4.19 3.37 -0.01 0.13 3.48 0.38 -0.34 3.14 3.53 273 This table reports the risk-neutral moments as estimated by the Gram-Charlier model implied in the 20 largest stock options and the FTSE 100 index option. and [5%.06 3.34 -0.20 3.33 4.15 3.45 -0.22 4.07 3.44 -0.35 -0. SCB 0. [0%.06 3.33 3.29 -0.29 -0.30 0.11 3.35 -0.92 0. 0%].18 0. ULV 0.20 -0.20 -0.47 129 14.69 0.55 0. BSK 0. and long-term over 240 days. SHL 0.21 0. whereas the sample period for each individual stock option varies.10 3.37 -0.14 4.59 0. 0.21 International Research Journal of Finance and Economics .06 3.13 4.61 -0.39 -0.20 4.33 4. HSB 0. the average implied volatility of the 79 individual stock options exhibits an asymmetric shape for short-term.09 3.19 3.31 -0.24 -0.81 0. TSB 0.35 0.26 3.43 -0. 1992 to December 31.05 3. 10%] for OTM calls. HAX 0.42 0.Issue 46 (2010) Short-term options Medium-term options Long-term options Ticker GCSTD GCSKW GCKUT GCSTD GCSKW GCKUT GCSTD GCSKW GCKUT Volume 1.09 3. the implied volatility curve subsequently becomes almost skewed in shape on average.23 4601 21.30 -0.16 0.26 -0.50 0.28 -0. displaying the results of the constrained estimate for the categorized sample data.31 4.23 0.38 -0.38 -0.08 3.49 0. medium-term.37 -0.43 0. ESX 0. BTG 0.36 -0.34 0.01 0. The last column displays the average traded volume per day. however.18 3.39 -0. relative to the availability of its price data.49 143 11.36 0.27 3. and long-term options before 1998.04 3. which is consistent with the FTSE 100 index option implied volatility shown in Lin.31 -0.69 179 15.19 3. -5%].19 4.84 0. The bottom row shows the average of the 79 individual sample stocks.04 0.79 18410 Tot Avg.06 0.30 -0.15 3. and long-term maturity.35 0. The log-moneyness intervals for OTM puts are [-10%.92 0. In Table 2.02 3.54 221 9.06 3.20 -0.18 4.33 -0.92 0.46 -0.66 903 12.65 42 2.12 3. As specified above.97 0.00 3.34 -0.03 0.54 0.21 4.73 719 3. RBS 0.28 -0.36 -0.42 -0.23 0.75 118 6.89 0.19 4.59 0.38 0.23 3. medium-term.18 4.38 391 7.08 1035 8.

72 36.04 31.12 22.33 32.12 23.71 28.68 24.69 24.35 53.58 51.89 24.94 29.08 24.71 25.18 38.58 25.67 25.87 39.64 24.62 24.50 40.34 1995 22.55 39.89 25.22 21.67 30.48 51.09 40.19 51.08 39.09 35.40 24.24 38.02 30.96 24.66 24.35 32.51 40.93 1993 25.30 32.97 21.International Research Journal of Finance and Economics .34 25.92 22.87 34.11 25.09 32.58 21.36 36.99 24.42 30.47 26.93 23.72 2001 40.49 24.14 31.58 30.48 41.45 26.55 24.26 1997 28.42 35.29 51.14 21.36 24.74 36.70 39.26 26.09 39.55 22.69 24.92 36.14 Figure 1: The Changing Nature of Average Implied Volatility Skew in 79 Individual Stock Options Panel A: 79 Individual Stock Options Average Implied Volatility Curve (1992) Panel B: 79 Individual Stock Options Average Implied Volatility Curve (1995) .02 29.59 40.36 29.20 51.30 30.29 25.30 37.67 1999 36.29 33.62 52.25 30.55 24.81 51.32 39.73 21.75 25.71 24.43 26.25 39.80 21.38 36.76 39.45 34.96 24.59 30.12 1994 25.83 24.01 22.09 26.20 31.Issue 46 (2010) Table 2: Average Implied Volatilities for Individual Stock Options across Moneyness and Maturity 22 Short-term options Medium-term options Long-term options OTM puts OTM calls OTM puts OTM calls OTM puts OTM calls Year -10% to -5% -5% to -0% 0% to 5% 5% to 10% -10% to -5% -5% to -0% 0% to 5% 5% to 10% -10% to -5% -5% to -0% 0% to 5% 5% to 10% 1992 26.51 24.43 39.67 24.91 1996 24.83 35.16 22.98 27.69 35.95 2000 53.75 24.76 37.30 1998 34.19 51.92 31.92 35.93 25.05 53.66 24.85 35.00 36.21 29.59 24.15 36.25 39.39 31.04 26.38 25.71 40.37 25.62 25.12 23.79 24.83 26.70 21.23 23.34 2002 41.36 53.15 26.96 24.34 22.87 31.99 1992–2002 31.

Independent Variables Here we outline why these explanatory variables are used and their construction. which represents the implied volatility slope as a dependent variable. Dependent Variable In order to quantify the implied volatility skew using options with a certain time to maturity. can be regarded as a measure of the magnitude of the implied volatility skew.23 International Research Journal of Finance and Economics . The Variables 3. N (19) where y i = K i / S is the moneyness of an option with the strike price K i . . A. .Issue 46 (2010) Panel C: 79 Individual Stock Options Average Implied Volatility Curve (1998) Panel D: 79 Individual Stock Options Average Implied Volatility Curve (2002) 3. we can measure the slope of the implied volatility curve using the following regression model. The variable is used to examine the hypothesis that higher volatility stocks have a steeper implied volatility curve. ln[ STD ( y i )] = π 0 + π 1 ln( y i ) + ε i i = 1. By regressing the logarithm of implied volatility on the logarithm of moneyness.2. the regression coefficient π1 . The model represented by equation (19) is estimated daily across our 79 stock samples using a least-squares estimation (LSE) method.2. There are N traded options with a specified time to maturity at a certain time. Option Implied Volatility The option implied volatility is estimated using the model of Gram-Charlier as a proxy for the volatility of an individual stock return. and long-term options. 3.1. medium-term. and the OTM puts and calls data is used for the short-term.

Beta Bakshi. Aijo (2003) also uses the time-varying exponentially-weighted moving average (EWMA) method-estimated beta to measure the market risk (detail in Aijo. preference capital. which is used as a proxy for investor sentiment or trading pressure in order to test whether the implied volatility curve is steeper when accompanied by a higher put options traded volume. The results of Dennis and Mayhew (2000) show that firm size has a positive relationship with the slope of the implied volatility curve. is the coefficient that relates the daily returns of stock i to the daily return of the FTSE 100 index from day t-250 to t. the purpose being to test how firm size influences the implied volatility skew and examine what level of firm size leads to a more negative slope of the implied volatility curve. leading the market value to decrease and the leverage ratio to rise. We use the endogenous variables as control variables in order to test the relationship between firm-specific variables and the slope. Volume We use the logarithm of daily trading volume (in shares) in the underlying stock as a proxy for the liquidity in order to test the hypothesis that the slope of the implied volatility curve is steeper for larger traded volume stocks. G. Kapadia. Leverage We define the leverage ratio as the sum of the total loan capital and preference capital divided by the sum of the total loan capital. The open interest data were also obtained from the LIFFE database. that is to say. F. and concludes that better regression results are achieved by using the EWMA model. Kapadia. and the market value of equity. Size Size is defined as the logarithm of the market value of equity. this leads to a more negative risk-neutral skewness implied in individual stock options. We want to test the hypothesis that a firm’s use of higher financial leverage leads to an implied volatility curve of a more negative slope. the flatter the implied volatility slope. and Madan (2003) show that when the S&P 100 index options implied risk-neutral skewness becomes more negative. We also use the put-to-call open interest ratio to test the robustness of our results. These results lead us to expect that the effect might be more pronounced if options are used to hedge the market risk when it is high. as measured by beta. Thus.t . In addition to using the traditional method-estimated beta as a measure of market risk. and we attempt to examine the hypothesis that the more negative the risk-neutral skewness. and Madan (2003) also clarify the relationship between the volatility smile and risk-neutral skewness and kurtosis. Risk-Neutral Skewness and Kurtosis These are endogenous variables obtained from the option prices and used to test the endogenous relationship between the option prices and their implied moments. These variables are estimated by the Gram-Charlier model. the steeper the implied volatility slope. and vice versa.Issue 46 (2010) 24 B. we test the hypothesis that the slope of the implied volatility curve is more negative for firms with more market risk. . and the slope of the implied volatility curve will become more negative. E. the financial risk and the stock volatility increases. 2003).International Research Journal of Finance and Economics . BETAi . The total loan capital and preference capital data are also obtained from the DataStream database. The beta for stock i at time t. D. and the more fat-tailed the risk-neutral distribution. when stock prices decline. Dennis and Mayhew (2002) describe a negative relationship between firm size and risk-neutral skewness in CBOE. Bakshi. in addition. C. Put-to-call Traded Volume Ratio Put-to-call traded volume ratio is defined as the total traded volume of put relative to the total traded volume of call for a certain time to maturity category on a certain day.

who show that the relationship between risk-neutral skewness and leverage is positive. respectively. – 0. SLOPEi . the coefficients of the variable leverage ratio are significantly negative. meaning stocks with higher market risk have a steeper implied volatility slope (higher volatility of stock return).t −1 proxies for other variables not included in this model1. the average of the slope of the implied volatility curve is –0.1235 and –0.t (20) where SLOPEi denotes the slope of the implied volatility for firm i. and the time lag variable SLOPEi .t + b3 SIZE i .t + b9 STD100 t + b10 SKW 100 t + b11 KUT100 t + b12 SLOPEi .t + b6 PUTCALLi .1.12 for medium-term options. Second. Empirical Results 4. large firms tend to have a smile of more negative slope.0486 for long-term options. who indicate that the market risk variable 1 Testing the multicollinearity among independent variables. STD100 t is the implied volatility of the FTSE 100 index option. Market-Wide Variables Additional systematic variables are included in the model to investigate the effect of market-wide factors on the implied volatility skew of individual stocks. and these results might indicate that the implied volatility is not a continuously-decreasing as shown in Figure 1.00 and 2. proxy for the volatility of the market. and whether the more fat-tailed the risk-neutral distribution of the index option. VIF values are all therefore less than 10. and 1. 1.0915 vs. –0.1025 vs. these variables are stock index option implied volatility.t + b5VOLUMEi . This is contrary to the prediction but consistent with the results of Dennis and Mayhew (2002) and Aijo (2003). and Dennis and Mayhew (2002). respectively. In Table 3 we show the results of the pooled regression analysis estimated by the generalized method of moments (GMM). STDi is the options implied volatility. risk-neutral skewness.71 for short-term options. This means that a firm with a larger volatility tends to have an implied volatility curve of less negative slope. SIZE i is the market value of equity.25 International Research Journal of Finance and Economics . respectively. We examined whether higher market volatility leads to a steeper implied volatility skew of individual stocks.t + b8 KUTi . If we define the twenty largest of the 79 individual stocks as large firms and the rest as small firms. the options implied volatility is positively and significantly related to the slope of the implied volatility curve. Third. SKW 100 t and KUT 100 t are the risk-neutral skewness and kurtosis of the FTSE 100 index option. the significantly negative coefficient on SIZE means a smile of more negative slope for large firms. for short-term options.00 and 1. who document a negative relationship between volatility skew and leverage. –0. 4. The Determinants of the Volatility Smile We use the following pooled time series and cross-sectional regression model to investigate the firmspecific and market-wide factors explaining the implied volatility skew (smile).Issue 46 (2010) H. the beta of the firm is negatively related to the slope of the smile. LEVERAGEi is the leverage ratio. First. estimated using the Gram-Charlier model. leading to higher volatility in stock price. the variance inflation factor (VIF) values are between 1. the flatter the implied volatility slope of individual stock options.t + b4 BETAi . BETAi is the beta of the stock’s return with the FTSE 100 index. and risk-neutral kurtosis.0515 for medium-term options. VOLUMEi is the stock’s traded volume (in shares). meaning that the multicollinearity problem is not serious. . in general.t + b7 SKWi .t −1 + ε i . PUTCALLi is the ratio of put-to-call traded volume. a proxy for the volatility of the market.0676 for large and small firms. and –0.57 for long-term options.00 and 2. Obviously.t + b2 LEVERAGEi . and SKWi and KUTi are the risk-neutral skewness and kurtosis. whether a more negatively skewed riskneutral distribution of the index option accompanies a steeper implied volatility slope of individual stock options.t = b0 + b1 STDi . which is consistent with the results of Duan and Wei (2009). meaning that firms with higher financial leverage tend to have a smile of steeper slope. Fourth. Previous results regarding this issue were reported by Toft and Prucyk (1997).

Our results show that while the market risk is high. and KUT 100 t has a positive relationship with the slope of individual stock options implied volatility curve. Fifth. indicating that greater volatility of the market is accompanied by a smile of steeper slope.1241 10. The evidence indicates that a more negatively skewed stock exhibits a steeper implied volatility curve. except for short-term options. Sixth. this shows persistence in the slope of the implied volatility curve for individual stock options. the results are mixed. Table 3: The Determinants of the Slope of Volatility Smile Short-term options Coefficient t-stat 0. Dennis and Mayhew (2000) show that a small options traded volume leads to this result.69** Medium-term options Coefficient t-stat 0.52** 0. suggesting that the positive coefficient on this variable was primarily driven by an illiquid traded volume. the stock price distribution also tends to be left-skewed. These variables that vary with time are instrumental in explaining the differential pricing of individual stock options.t −1 proxy for other variables not included in the model has a positive coefficient. this leads to higher volatility in stock price in the future. we also use the most liquid data and replace the variable by put-to-call open interest ratio in order to test the robustness. In this study.50** Long-term options Coefficient t-stat -0.e. meaning that when the market is pessimistic. indicating that the steeper (flatter) the slope of the implied volatility curve. and that on KUT is the same. Kapadia. which is consistent with the results of Bakshi. Chang. and use the most active observations to test the robustness. In order to compare the influence of firm-specific and market-wide factors.Issue 46 (2010) 26 plays a role in option pricing.08 0. the results indicating that the more negative (less negative) the skewness. with the exception of the short-term options data. and Paxson (2008). we drop the marketwide variables from the regression equation.0770 3. discovering a negative relationship between put-to-call traded volume ratio and the slope of the smile. and investors tend to worry about the down side of the risk.36** 0. Chauveau and Gatfaoui (2002) add systematic risk into the option price model to consider the effect of the volatility of the market factor and the beta on option prices.0182 3. we predict that a negative relationship exists between put-to-call traded volume ratio and the slope of the implied volatility curve as a measure of market sentiment. While the market is of a more left-skewed distribution. For the endogenous variables. Finally.International Research Journal of Finance and Economics . however.0010 -0.. and that systematic risk must be incorporated into the option price model in order to capture the impact of systematic risk on option price. This result is consistent with that of Dennis and Mayhew (2002). the use of options to hedge this risk is more pronounced. that the coefficient on traded volume is negative means steeper implied volatility curves for more liquid stocks: the more liquid the stock. and Madan (2003) and Lin. and leptokurtic risk-neutral kurtosis leads to a flatter slope of implied volatility. the steeper (flatter) the next day’s slope. In a recent study. as the volatility of underlying price becomes larger. it is accompanied by more negative skewness and a fat-tailed stock price distribution.0167 3. and the less (greater) the risk-neutral kurtosis for the stock index option. and with a higher volatility of stock prices. In general. The market-wide variable STD100 t has a negative relationship with the slope of individual stock options implied volatility curve. which displays the expectation of underlying prices by investors. the steeper (i. who find that the firm-specific factors have much more influence on the slope of smile. and find that the adjusted r-square for the firm-specific variables is much larger than that for the market-wide variables. the coefficient on SKW is significantly positive. the time lag variable SLOPEi . These results can increase investors’ awareness of the impact of the market on the share price of individual companies. the higher the volatility in stock prices.99** Variables Intercept STD . SKW 100 t has positive coefficients. Empirical findings from market-wide variables also show that the overall market volatility or investors’ prediction of the stock market index exhibits a similar volatility trend to the stock price of individual companies. more negative) (flatter) the slope of the implied volatility curve for the individual stock options.0483 4.

08** -0. nonsignificantly negative for medium-term options.6174 26.0674 17.43 0.18 0.96 -0.0000 -3.20** -2.27 LEVERAGE SIZE BETA VOLUME PUTCALL SKW KUT STD100 SKW100 KUT100 SLOPE t -1 International Research Journal of Finance and Economics .58** 5.31** -0.7030 0. Second. reflecting whether investors will feel bullish or bearish in the future. we also group the sample options into three categories in order to examine the analysis across maturities.94* -2.54** 0. who report that the positive coefficient on the variable putto-call traded volume ratio was primarily driven by illiquid traded volume. which does not explain the smile of implied volatility. this might explain the demand on short-term and medium-term put options in order to defend the downside risk. Liquid data are defined as the sum of the call and put options traded volume in the upper quartile of each time to maturity category at a certain time. put-to-call traded volume ratio does not represent the sentiment of investors desiring more put options to defend the underlying downside risk. In this instance.0000 ** 0. and if the remaining time to expiration falls between 181 and 270 days.95 -0.0155 -0. 4.0034 -4. First.44 -0.0058 -4. The coefficient on put-to-call traded volume ratio is non-significantly positive for short-term options.53 2. the option is grouped in the medium-term category.59** -0. put-to-call open interest ratio can better represent the sentiment of investors than put-to-call traded volume ratio.0329 5. In summary.0035 3.10 4.0033 -0. The results remain the same as for the previous category definitions of option maturity.2. therefore.0001 0. and ** denotes the test is significant at the 5% level.0014 -1. .49** 0.13** -0.89** -0. we can find no evidence to support the results of Dennis and Mayhew (2000).7953 17.0048 -7.0326 9.17 0.0003 -0.0042 -0. and is non-significantly negative for long-term options. remains the same for medium-term options. we use put-tocall open interest ratio to replace the variable put-to-call traded volume ratio in equation (20).6077 0.63** 0.0688 0.06** 0.4774 0.86** -1.56** 0. For the robustness testing of another category of maturities.48 -0.0000 2.1002 -0.0090 6.0022 -4. we also use the liquid data to test the robustness of the trading pressure variable.96 0. if the remaining time to expiration falls between 91 and 180 days. If an option has a remaining time to expiration of between 9 and 90 days.64** 0.4847 Adjusted R 2 * Denotes the test is significant at the 10% level.13 -0.42** -2.46 0. and investors may hold a larger position on long-term call options. it is grouped in the short-term option category.0129 -11.0074 3.0000 -0.72** 0.20** 4.0000 ** -0.0082 -0. Robustness Tests We also test the robustness of the results described above.0000 -2.14** 0.0060 ** ** 0.0149 -1. as shown in Table 4.0077 -0. and significantly positive for long-term options. the option is grouped in the long-term category.14** 0.39** -0.0017 0.Issue 46 (2010) -2. These results reflect that investors feel bearish in the short term and bullish in the long run. As the coefficient on put-to-call open interest ratio is significantly negative for short-term options.

09 7.0402 4.0087 0. and ** denotes the test is significant at the 5% level. Panel C: Long-term options Open interest Coefficient -0.7137 0.88** SLOPE t −1 0.8216 51.0031 -0.56 Variables Intercept STD LEVERAGE SIZE BETA VOLUME PUTCALL PUTCALLOI SKW KUT STD100 SKW100 KUT100 .0133 0.14** -2.0000 0.0695 -0.77** ** SLOPE t −1 0.0029 -0.6230 30.0224 8.0003 0.8064 19.0005 0.00** 4.20 STD100 -0.0075 2.0036 3.0009 -0.0737 -0.35** -0.99 0.27** ** STD 0.0470 4.26** -1.19** -0.0647 0.09** -2.74 VOLUME -0.0124 -12.0014 0.7307 Adjusted R 2 * Denotes the test is significant at the 10% level.0062 Most liquid t-stat -0.5313 t-stat 7.0076 4.05** 3.0824 -0.52** BETA 0.0015 0.05** KUT 0.0643 19.0337 10.30** -2.13** STD 0.40 0.0147 3.0654 0.0906 0.1125 11.89** -2.0000 0.46** -3.0000 3.98 2.0012 0.72** 0.89** Coefficient 0.15** 4.36** -0.0303 5.51** 3.06** SIZE -0. Panel B: Medium-term options Open interest Most liquid Variables Coefficient t-stat Coefficient t-stat Intercept 0.34 0.70** -2.0043 0.95** 28 Open interest Variables Coefficient t-stat Intercept 0.0055 -0.94** STD100 -0.0085 0.77 3.86** -4.70** SKW 0.66** SIZE -0.0100 6.0113 -0.0000 -0.11** KUT100 0.88 0.28** 0.0011 -1.0042 3.0026 0.50** BETA -0.0083 -0.0071 -6.23 -8.0141 -0.09** 0.0000 -3.02** -2.0391 0.0160 0.0000 -0.62** LEVERAGE -0.80** 17.0010 -2.0032 -4.0000 -3.0043 -7.Issue 46 (2010) Table 4: Panel A: Robustness Analysis Short-term options Most liquid Coefficient 0.0101 1.1249 0.22 -0.11 1.0134 -0.0061 -0.0150 -1.0000 -0.89 -0.95** -1.02** -0.66** 0.29 SKW100 0.66* -0.75 VOLUME -0.70 10.62** ** KUT100 0.0120 -1.78** -0.0052 -4.41** 2.37 SKW100 0.0037 -0.15** -2.0000 -0.0000 -3.80 0.6297 0.0004 0.55** 0.0071 -0.06** 4.4799 Adjusted R 2 ** Denotes the test is significant at the 5% level.68 4.72** PUTCALL PUTCALLOI -0.32** PUTCALLOI -0.0103 -0.International Research Journal of Finance and Economics .0020 -5.20 SKW 0.27 -3.0157 3.0430 -0.22 LEVERAGE -0.46** 0.29** KUT -0.57 -2.29** 0.0002 -0.0029 0.26 PUTCALL 0.0025 t-stat 0.31** 0.

and the greater the kurtosis of the FTSE 100 index option. the steeper the volatility smile of individual stocks. The more negative the skewness of the FTSE 100 index option. In this study we first use the Gram-Charlier model to price American equity options. First. .7926 0. In general. and larger traded volume firms tend to have an implied volatility curve of more negative slope. firm size. the results indicate that the variable put-to-call open interest ratio can best represent the sentiment of investors. On average. Our empirical results may help to understand the influence of firm-specific and market-wide factors on the slope of the smile in LIFFE equity options. higher market risk firms. In the analysis of robustness. Persistence of the slope of the smile is also in evidence. Second. meaning that a higher volatility market is accompanied by greater volatility of stocks. firms using higher financial leverage. the flatter the implied volatility slope. we show that firms with a larger volatility of stock return tend to have an implied volatility curve of less negative slope. the flatter the volatility smile of individual stocks. and the more fat-tailed the risk-neutral distribution. and find that firm-specific variables such as leverage ratio. larger firms. The put-to-call traded volume ratio is non-significantly related to the slope of the smile for short-term and long-term options. and use Gram-Charlier series expansion to approximate the distribution of the logarithm of the stock price. The category of maturity does not on average influence the empirical results.29 International Research Journal of Finance and Economics .5121 Adjusted R 2 ** Denotes the test is significant at the 5% level. the more negative the slope of the smile of individual stocks. this method providing another theoretical formula with which to model option price.Issue 46 (2010) 5. beta. we also examine how market-wide variables influence the slope of implied volatility of individual stocks. even though we use the most liquid data to test the robustness. and significantly positive for medium-term options. 5. Conclusion In this article we examine the firm-specific and market-wide factors explaining the implied volatility skew (smile) in LIFFE equity options. and traded volume provide useful explanations for the slope of the smile. The results indicate that the higher the volatility of the FTSE 100 index.3223 33. the steeper the implied volatility slope. the more negative the risk-neutral skewness. incorporating non-normal skewness and kurtosis terms in the adjusted option price to expand the option price formula of Merton (1973) as a theoretical model and estimate the risk-neutral moments by numerically solving the nonlinear least-squares problem.98** 0.6376 0. we cannot show that investors wish to attain a larger position in put options to hedge the downside risk.65** SLOPE t −1 0.

and L. “Analytical Upper Bounds for American Option Prices”. pp. pp. “Skewness and Kurtosis in S&P 500 Index Returns Implied by Option Prices”.. “The Pricing of Options and Corporate Liabilities”. S.. Lim. C. Dennis. 2000. Duan. pp. Research Foundation of AIMR. 117-135. R... 12. “Determinants of the Volatility Smile: A Study on the German Individual Stock Options”. Rockinger. 2001.. and M. 1457-1483. 2007. 10. 471-493. P. pp. 22. 1997. Brandt. I. Mayhew. S. J. 2002. Chang. Chen. 209-227. Journal of Applied Econometrics. Martin. R. A. Journal of Financial Economics. pp. Lai. Melick. 91-115. and C.. B.. J. C. G. Jondeau. H. “Implied Volatility Smiles: Evidence from Options on Individual Equities”. A. 37. Journal of Financial and Quantitative Analysis. pp. Review of Financial Studies. 175-192. and A. and M. Dennis. and T. E. K. 2003. New York University. pp. Journal of Economic Dynamics and Control. R. Bakshi.International Research Journal of Finance and Economics . “Generalized Analytical Upper Bounds for American Option Prices”. “The Information Content of Implied Volatility. Journal of Financial Research. K. 19. and the Differential Pricing of Individual Equity Options”.. pp. D. Journal of Financial and Quantitative Analysis. 2002. 2002.. J.. 37. Gatfaoui. “Risk-Neutral Skewness: Evidence from Stock Options”. and D. pp. pp. and M. “Stock Return Characteristics. and S. Chauveau. F. Foresi. pp. C. Journal of Financial and Quantitative Analysis. 1957-1987. 1973. Beber. 2006.. 32. Skew Laws. “Theory of Rational Option Pricing”. pp. “Accounting for Biases in Black-Scholes”. 377-404. “Systematic Risk and the Price Structure of Individual Equity Options”. pp. Lin... “Systematic Risk and Idiosyncratic Risk: A Useful Distinction for Valuing European Options”. S. Kapadia. Jackwerth. Thomas. 2005. University of Vaasa. Journal of Political Economy.. Paxson.Issue 46 (2010) 30 References [1] [2] [3] Aijo. Journal of Banking and Finance.. Chang. 1982. working paper. F. European Financial Management. P. T. 1973. P.. Coutant.. “The Effect of Macroeconomic News on Beliefs and Preferences: Evidence from the Options Market”. working paper. M. Journal of Multinational Financial Management. 1997. C. Black. 81. and V. pp. and M. Su. 2008. pp. 141-183. “Smiling Less at LIFFE”. Rudd.. Option-Implied Risk-Neutral Distributions and Risk Aversion. Merton. Skewness and Kurtosis: Empirical Evidence from Long-term CAC 40 Options”. 2004. G. Backus. “Gram-Charlier Densities”. J. Journal of Futures Markets. Yeh. 167-179. “Reading PIBOR Futures Option Smiles: The 1997 Snap Election”. 1996. 1997-2039. 637-659. 28. Madan. Chung. 57-81.. 41-56. and C. 25. 16. and H. “The Pricing of Commodity Contracts”. pp. R. Villa. and D.. 42. L. C. pp. 3. J. Wei. Scholes. Journal of Financial and Quantitative Analysis. mimeo. 347-369. and J. 2000. Corrado. Wu. and H. and S. 2003. W. Martin. Journal of Monetary Economics. Mayhew. Navatte. 20.. 305-321.1981-2006. Black. 101-143.. L. 2001. 53. 2009. “Approximate Option Valuation for Arbitrary Stochastic Processes”. Jarrow. “Recovering an Asset’s Implied PDF from Option Prices: An Application to Crude Oil during the Gulf Crisis”. “Parametric Pricing of Higher Order Moments in S&P500 Options”. 4. W. 1976. P. Journal of Financial Economics. and S. G. [4] [5] [6] [7] [8] [9] [10] [11] [12] [13] [14] [15] [16] [17] [18] [19] [20] [21] [22] . E. Jondeau. Rockinger. University of Virginia. Review of Financial Studies. pp. N. R. 6. 25. Bell Journal of Econometrics and Management Science.

Serna. “Higher Order Asymptotic Option Valuation for NonGaussian Dependent Returns”. Watzka. Tamaki. and J. 1151-1179. G. Vahamaa. pp. and M. K. 52. Prucyk. “What Moves Option-Implied Bond Market Expectations?”. “Options on Leveraged Equity: Theory and Empirical Tests”. Journal of Strategic Planning and Inference. 23. Taniguchi. and B. Journal of Finance. 25. pp. .. 817-843. 1997. I. Aijo. Journal of Futures Markets. Toft. S. K. pp.31 [23] [24] International Research Journal of Finance and Economics . 10431058. 2006. and G. A. Rubio. 1151-1180. 1999. 137.. Journal of Banking and Finance. 2005. pp.. “Why Do We Smile? On the Determinants of the Implied Volatility Function”..Issue 46 (2010) [25] [26] Pena.

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