Journal of Accounting and Economics 1 (1979) 117-140.

0 North-Holland Publishing Company

ANTICIPATED INFORMATION RELEASES REFLECTED IN

CALL OPTION PRICES

James M. PATELL and Mark A. WOLFSON*

Stmji~rd University, Sranford, CA 94305, USA

Received August 1978, revised version received February 1979

This study captures the ex ante information content of a financial reporting event (the annual
earnings announcement) by examining the behavior of call option prices on dates leadmg up to
and passing through the disclosure date. This approach differs from most previous emplrical
security price research which has been rx post in nature. The hypothesis that investors anticipate
that the future release of annual earnings numbers will affect security prices is empirically
confirmed. In particular, systematic changes in variance rates implied by the Black Scholes
option pricing model are demonstrated.

1. Introduction

A significant portion of empirical accounting research has sought to

demonstrate that financial accounting disclosures contain information which
affects security prices. Most of these studies have required the specification of
a model of investor expectations concerning signals to be released, in order
to nominally classify sample firms according to whether the realization of the
real-valued signal exceeded or was exceeded by its expectation. A somewhat
smaller collection of studies report unusually large price changes at the
disclosure date, without regard to sign.2,
All of these studies are ex posr analyses, in the sense that they demonstrate
what a large sample of security prices actually did on the date of an
accounting disclosure. The research reported here attempts to capture e.~
ante the anticipated information content of a financial reporting event (the
annual earnings announcement) by examining the behavior of call option
prices on dates leading up to and passing through the disclosure date. Call

*This research was sponsored by the Stanford Program in Professional Accounting, major
contributors to which are: Arthur Andersen & Co.; Arthur Young & Co.; Coopers and
Lybrand; Deloitte, Haskins & Sells; Ernst & Ernst; Peat, Marwick, Mitchell & Co.; and Price
Waterhouse and Company. The authors acknowledge the research assistance of Theodore Day
and Neal Ushman, and the helpful comments of Stanley Baiman, John Cox, Roland Dukes,
Thomas Dyckman, Nicholas Gonedes, Yuji Ijiri, and particularly Clifford Smith.
Ball and Brown (1968) conducted the first major financial accounting research study of this
form.
*See, for example, Beaver (1968).
118 J.M. Pate11 and M.A. Woljbon, Anticipated informurion in call options

options provide a particularly appropriate instrument for this type of

research because of the relationship between their value as a contingent
claim and investor beliefs about the future stochastic behavior of the
underlying stock price over the remaining life of the option contract.
The methodology of this study is designed to test for changes in the
variances of common stock returns. This differs from previous security price
accounting research which has focused primarily on changes in mean returns
to detect information content. We begin with a simple model in which
market participants expect the date of an information release to be a period
in which stock price variability is temporarily above average. In such a
situation, certain attributes of the price of a call option expiring shortly after
the disclosure date can be deduced. The Black Scholes (1973) option pricing
model enables us to infer from option prices the expected stock price
variability at dates surrounding the earnings announcement. A time series of
option prices can reveal the anticipated increased security price variability
even if, ~J.Ypost, the announced signal has little or no effect on stock price.
Hence, this study focuses on investors assessment of signal generating
processes or mechanisms rather than on their reaction to particular signal
realizations.
Section 2 describes the Black--Scholes option pricing model and indicates
how the model can be used to detect anticipated changes in stock price
variability. In particular, we demonstrate that the sensitivity of call prices to
anticipated information releases should increase as the expiration date of the
option approaches. Sections 3 and 4 describe the basic experimental design
and the sample data. In section 5 we report statistical results which are
consistent with the hypothesis that call option prices reflect investors C_Yante
beliefs that the annual earnings announcement date will be a period of
increased security price variability. Section 6 discusses methodological prob-
lems in using option price data and describes tests of the sensitivity of the
empirical results to data specifications. Section 7 briefly summarizes the
study and indicates several other areas of accounting research which may be
explored through the analysis of option prices.

2. The option pricing model and non-constant variances

The BlackkScholes (1973) valuation formula for call option prices depends
upon only five variables, four of which are directly observable. Specifically,
the Black-Scholes model may be written as follows:

C=SN(d,) -Xe-r7N(d2j.

d, =(ln(S/X)+(V+1~2)T)/(~v/T)

dz =d, -o,/?T,
 J.M. Pate/l und M.A. Wolfson, Anticipated informahn in cull options 119

where

C E call price,
S = stock price,
X -exercise price of the option,
T = time to expiration of the option,
r ~continuous risk-free rate of interest per period,
0 ~standard deviation of continuous returns on the stock per unit time.
N ( 1 = cumulative standard normal distribution function.

Since we wish to derive implied variance (or standard deviation) rates on

the underlying stock at various points in time, the Black-Scholes valuation
formula is especially appealing, because the ordered quintuple (Y, 7; X, S, C),
each element of which is directly observable, maps into a unique (r:
In order to derive the closed form solution shown above, Black-Scholes
assume that the variance of the return on the underlying stock is constant
through time. While the Black-Scholes valuation formula does not strictly
hold if the variance rate on the underlyin, u stock is stochastic, the results of
LatanC- Rendleman (1976) and Schmalensee-Trippi (1978) suggest that the
model still performs well in the face of variance changes. Perhaps more
importantly, it can be seen from Merton (1973, pp. 162-~167) that the Black-
Scholes valuation formula is virtually unchanged when the variance rate is
changing as a known function of time. The only difference is in the definition
of r?. Whereas in the BlackkScholes formulation (T is the constant in-
stantaneous variance rate of return on the underlying stock, C? can be
somewhat more generally defined as the average variance rate per unit time
from the valuation date to the option expiration date,

a(T) = T- j rr2(t)dt,
0

where o(t) is the instantaneous variance at time t. If a2(t) is equal to a

constant (the Black-Scholes assumption). then it is obvious that d(T) is
equal to the same constant.
This interpretation is especially useful for our purposes. Since we are
examining the effect of information releases which will take place at a known
point in time, the market may anticipate temporary changes in stock return
variances associated with the information release. The average-variance-to-
expiration-date interpretation motivates our more general usage of the

There have been several recent efforts to use a variant of the Black-Scholes formula to derive
implied variance rales: Latant and Rendleman (1976). Schmalensee and Trippi (1978), Becker%
(197X), among others. In each of these studies, the implied variance rates were used to forecast
future variance realizations.
The other Black-Scholes assumptions and their relation to our empirical tests will be
discussed in section 6.
120 J.M. Pate11 and M.A. Wobon, Anticipated inforrnution in cull options

Black-Scholes model to address the issue of whether the market anticipates

that the release of annual earnings announcements will have information
content.
We utilize the average variance interpretation by postulating a simple
model of the variance profile, illustrated schematically in fig. 1, in which the
securitys variance is expected to increase during periods of accounting
information disclosure.

Fig. 1. Instantaneous variance profile of a common share with one anticipated information
event.

Variance (or standard deviation) appears as the ordinate in fig. 1, and is

expected to remain relatively level (normalized to a value of 1.00) during the
period from t = - 4 to t =O, which might be described as a period of normal
information arrival. However, if it is publicly known in advance that a major
accounting information release will be made at time t =O, even though the
content of the release itself is unknown, one might anticipate increased
variance during the period immediately following the disclosure. The
variance profile depicted in fig. 1 imparts a particular shape to the series of
expected average variunces to expiration derived from call option prices on
the dates surrounding the disclosure period. Fig. 2 plots the average variance
to expiration6 for two options, one expiring at t = +2 and one expiring at t
= f3.
The expected average variance to expiration rises to a maximum im-
mediately preceding the disclosure due to the steady decrease in the time to
expiration, which constitutes the denominator of the average. Once the
disclosure is made, and its effects, if any, are assimilated into the security
price, the average variance drops to its normal level. Note that the

*See Beaver (1968).

For each observation date, oL(T) is equal to the area under the curve in fig. 1 from the
observation date, t, to the expiration date, t,,,, divided by T= Ct.__
- r).
 J.M. Pate11 and M.A. Wolfson, Anticipated information in call options 121

Fig. 2. Average variance to expiration with one anticipated information event

magnitude of the effect increases as the expiration date of the option is

moved closer to the disclosure period.
In order to experimentally detect the effects illustrated above, we compute
implied average variances from the prices of call options which expire shortly
after an accounting disclosure whose date can be accurately predicted, such
as an annual earnings announcement. The sequence of prices preceding the
earnings announcement date should imply increasing expected average
variance, while those after the announcement would imply a reduced average
variance. The largest (and therefore perhaps the easiest to detect) change
occurs at the disclosure date. If the adjustment of security prices to the
information release is not instantaneous, the implied average variance might
continue to fall for a time after the disclosure until the information becomes
fully reflected in equilibrium prices.
A second experimental design is suggested by considering the relative
average variances implied by two options which expire at widely separated
dates following the earnings announcement. Two such options are illustrated
in figs. 3 and 4.
Also note that if the expiration date preceded the disclosure period, there would be no effect
on the expected average variance to expiration, which would remain level at 1.0, according to
the simple instantaneous variance series shown in fig. 1.
122 J.M. Pate11 und M.A. Woljbn, Anticipated information in call options

Fig. 3. Instantaneous variance profile of a common share with two anticipated information
events.

Fig. 4. Average variance to expiration with two anticipated information events.

The shorter option expires at t = + 3, and its expected average variance to

expiration curve is identical to the lower curve shown in fig. 2. The longer
option expires at t= +9, and fig. 3 allows for the possibility that this longer
life may extend through the date of a second publicly anticipated disclosure
event (shown here with a smaller expected increase in security price
variance). Three interesting phenomena become apparent.
If two call options are identical in all respects except expiration date, and
both terms to expiration include a single anticipated information disclosure
(see fig. 2):

(1) The average variance implied by the price of the shorter option will
exceed the average variance implied by the simultaneous price of the
longer option on dates preceding the information disclosure date.
 J.M. Pate/l and M.A. Wo!fson, Anthpated information in cull options 123

(2) The rise and subsequent decline of the average variance implied by the
longer options prices will be less extreme than that implied by the
shorter options prices.

If the longer call options term to expiration includes a second anticipated

information disclosure event occurring after the expiration of the shorter
option (see fig. 4):

(3) The average variance implied by the price of the longer option will
exceed the average variance implied by the shorter options price on
dates following the first information event.

The long versus short (time to expiration) average variance comparisons

are affected by the magnitude and timing of the security price variance
change at the second information event. If the second event is expected to
induce a significantly smaller change in the underlying stocks variance than
the first, conditions one and two continue to obtain, while condition three is
diminished. Alternatively, if the second event is expected to induce a much
greater change in security price variance than is the first event, conditions
one and two are reduced, or, in the extreme, reversed, while condition three
is magnified.
The existence of this second set of hypothesized expected average variance
phenomena could be investigated by the examination of simultaneous price
data surrounding annual earnings announcements for call options of different
maturities. Since the concurrent options will differ in expiration date by
approximately ninety days, the second information event depicted in figs. 3
and 4 has a natural interpretation as a quarterly earnings announcement.

3. Experimental design

The analysis presented here will concentrate on detecting the hypothesized

expected average variance behavior depicted in fig. 2, for options which
expire shortly after the firms annual earnings announcement. The annual
earnings announcement date appears to be relatively easy to predict,* and
many prior research studies using common stock prices have drawn the
inference that the earnings disclosure contains significant information con-
tent. Evidence on the expected average variance implied by the prices of
options which expire at a greater interval after the earnings announcement
will also be presented.
Call option prices were observed at weekly intervals beginning four weeks
prior to the earnings announcement and continuing until two weeks after the
disclosure date. Since we are especially interested in the behavior at the
announcement date itself, daily observations from two days before through

See table 1.
124 J.M. Patell and M.A. Wo!fson, Anticipated iqfimnation in cd options

one day after the announcement were also collected. By computing the
expected average variances to expiration implied by these prices, plots
corresponding to fig. 2 can be constructed.
To test the significance of changes in average variance, the differences in
each firms implied average standard deviation to expiration for successive
weeks were computed. Considering every difference of the form Z,,, there are
45 such comparisons,

zij = Gj - & i=-4 wk,..., +l wk,

j=i+l wk (day),..., $2 wk,

where gi E implied average variance to expiration at time i.

The hypothesized variance profile of fig. 1 implies the following matrix of
expected signs of the Zij.

.i=
~ 3 wks. ~ 2 wks. - 1 wk. -2 days - 1 day 0 +lday flwk. +Zwks.

= -4 wks. + + + + + _ _ _
- 3 wks. + + + + _ _ _ _
-2 wks. + + + _ _ _
-1 wk. + + _ _ _ _
- 2 days + _ _ _ _
-1 day _ _ _
0* O/- Ol- O/-
+ 1 day** 0 0
+1 wk. 0

*If security prices adjust instantaneously, the entries in this row would all be zero. When thl
period of adjustment to information disclosure exceeds one day, the signs are expected to bl
negative.
*A condition similar to that of the 0 row exists if the period of adjustment exceeds two days.

Fig. 5. Predicted signs of the changes in average standard deviation to expiration (Z,,) implied
by call option prices.

Of course, not all of the 45 comparisons are independent; e.g., Z-,, _ z is

not independent of the pair ZP,, m3 and Z_,, m2. For that reason, we will
report the diagonal elements Zij which correspond to the sequential weekly
(or in three cases daily) changes in implied average standard deviation. The
behavior modeled in fig. 2 implies five positive differences followed by a large
negative difference occurring between minus one day and plus one day,
followed by two zero differences. In order to capture the predicted decline at
The sequential (diagonal) elements may or may not be independent depending on the time
series process generating observed call option prices.
 J.M. Patell and M.A. Wo!fson, Anticipated information in cull options 125

the announcement date, the off-diagonal element Z_ I day,+ , day will also be
reported.
Two tests of the significance of the Zij are presented: the Fisher signs tests
and the Wilcoxon signed ranks test. Each test models the process generating
the successive average variance differences as

pj=Q+;;j, k = firm index.

The null hypothesis of each test is stated as

H,:H=O,

and for those cases in which a specified sign is predicted for Ze, a one-sided
significance test is appropriate.
Both the Fisher signs test and the Wilcoxon signed ranks test assume that
the Pi: are independent (across firms) and that each iFJ is drawn from a
continuous population (not necessarily the same one for each firm) with
median zero. The Wilcoxon test further assumes that the distributions of Efj
are symmetric about zero, and since the test uses information on the ranked
magnitudes of the zfj realizations, it may be sensitive to scaling problems in
0. To check the symmetry condition, the Gupta non-parametric symmetry
test was performed and indicated no significant departures from symmetry in
the zfj distributions. In general, the Fisher test is the less powerful, but it
makes fewer demands on the data. Both statistics have large sample
asymptotically standard normal representations, and both were computed for
all Zij comparisons.
Call option price data for options with a longer period to expiration were
also collected at each date. Implied average standard deviation plots similar
to those for the shorter options were constructed and sequential Zfj
significance tests were carried out.

4. Sample

The sample consists of all non-12/31 fiscal year firms listed on the Chicago
Board or the American Options Exchanges in December, 1976, for which the
Wall Street Journal Index contained at least one annual earnings announce-
ment during the period January, 1974 through June, 1978. We identified 28
such firms, yielding a total of 83 annual earnings announcements, as
tabulated in table 1. Each date is the earliest announcement appearing in the
Index. Table 1 indicates that there is little variation from year to year in each
firms announcement date, which lends credence to our assumption that the
timing of the disclosure is easily predictable.

The common stock of 1 firm was listed on the American Stock Exchange; the remaining 27
were listed on the New York Stock Exchange.
126 J.M. Pate11 and M.A. WolJkm, Anticiputed information in cull options

Table 1
Wall Street Journal annual earnings announcement dates for sample firms

Firm 1974 1975 1976 1977 1978

Avnet 9/08 9109

Beatrice Foods 3123 4127 4126
Black & Decker 10/17 10/22 10/21
Deere 12110 12108 12107
Delta 7125 7/23 7129
Digital Equipment 8/07 8117 S/IO
Disney 1 l/O7 1 l/O4 lljll
Fleetwood 5/14 5125 5,30
Fluor 12113 12113
General Foods 5:27 5126 5125
Gulf & Western 1 l/O1 9123 10127
Hewlett-Packard 1126 1 t/22 I l/25
Internaltonal Minerals 8,l I s/o5 8/04
Kresge 3112 3110 3109 3115
Loews 3117
National Semiconductor 7~12 7106 6126
Norton Simon 8/l I 8110
Penney 3110 3109 3109
Proctor & Gamble 8114 S/18 X/18
Rite Aid 4107 4107 4105
Sears 3119 3/l 1 3;19 3123 3/22
Simplicity Patterns 3125 3128 3123
Skyline ($22 6122 6/26
Sperry Rand 5102 S/O1 4130 4129 4/2X
Syntex (AMEX) s/02 9/0x 9/0x
Tandy 8/20 8124
Tesoro I l/l I 12106 12119
Walter (Jim) IO/16 lo/l5 lo/l4

Our restriction of the sample to non-12/31 fiscal year firms was motivated
by a desire to mitigate problems of non-independence among the sample
observations. I While this restriction eliminates January and February
announcements, it leads to a broad distribution of observation dates. It may
be informative to compare our sample with those selected in other studies
which generated implied variances from the BlackPScholes model. Latani:
and Rendleman (1976) utilize 24 firms (21 with a calendar fiscal year) over
the period 10/5/73 to 6/28/74. Schmalensee and Trippi (1978) studied 6 firms
(all with a calendar fiscal year) over the period 4/29/74 to 5/23/75. Beckers
(1978) uses 48 firms (37 with a calendar fiscal year) over the 75 day period
from 10/13/75 to l/23/76. Our sample of 28 firms yields 83 separate firm-
option test periods over the four and one-half year interval 2/12/74 to
7/l l/78.
For each firm, daily closing call option and stock prices were collected

See Beaver (1968) for discussion of a similar exclusion rule in a study of price variability.
 J.M. Pate11 and M.A. Wolfson, Anticipated informution in cull options 121

from the Wall Street Journal for each of the following ten dates relative to
the earnings announcement: -4 weeks, - 3 weeks, - 2 weeks, - 1 week, -2
days, - 1 day, 0 (announcement date), + 1 day, + 1 week, and +2 weeks.
Call prices were collected for all available exercise prices (numbering from
one to six, and typically three or four) and for two different official maturity
dates. The short option was the first option expiring at least two weeks after
the earnings announcement date. The long option was the one expiring next
after the short option (approximately three months later).*
The necessary inputs for the standard deviation calculations are stock
price, call price, exercise price, option expiration date, dividend dates and
amounts (for all dividends between the observation date and the option
expiration date), and the relevant risk-free interest rates. Option expiration
dates, exercise prices and closing stock and call prices were taken from the
Wull Street Journul. Ex-dividend dates and amounts were collected from the
Daily Stock Price Record for the New York and American Stock Exchanges.
The means of the bid-ask discounts on U.S. Treasury Bills were collected on
a weekly basis from January, 1974 through July, 1978 from the Wull Street
Jourml for maturities of 1, 30, 60, 90, and 180 days.
For each call price observed, the BlackkScholes valuation formula, adjus-
ted for dividends as discussed in section 6, was used to compute the implied
average standard deviation per unit time to expiration. Since an analytical
solution to the BlackkScholes equation cannot be solved for 0, a simple
numerical search program was employed.iS The implied standard deviations
for the various available exercise prices were arithmetically averaged
(across exercise prices) separately for each firm, at each of the ten dates
of interest, for each of the two expiration dates.
A number of potential call price observations were lost when no trade
took place for that option on the observation date. Further observations
were discarded when the implied standard deviations could not be computed,
i.e., the stock price, adjusted for dividends, exceeded the sum of the
discounted exercise price and the call price. In a frictionless market, such a
situation implies arbitrage profits. As discussed in section 6, the apparent
arbitrage profit opportunities are largely due to non-synchronous reporting
of call and stock prices. Careful consideration of the process generating these
observations led to further data restrictions: all observations with a term to
expiration of thirty days or less were excluded, and observations were
restricted to those options trading at prices of one dollar or more. Our

At any given point in time, options with as many as three different expiration dates may be
trading for each exercise price available.
13For any discounting over a time interval of length 7; we selected the Treasury Bill rate
whose term was closest to 7; as quoted on the date nearest (within three days) to the call price
observation date.
l4The search program is a variant of a successive approximation routine written by William
Sharpe (July, 1974). Implied variances were calculated to six significant figures.
128 J.M. Pate11 and M.A. Wo&m, Anticipated information in cull options

motivations for these restrictions, together with other empirical testing

details, are presented in section 6.

5. Empirical results

Figs. 6 and 7 present quartiles of the time series of implied average

standard deviations for the short- and long-term options, respectively. Only
firms with a complete record of observations from -4 weeks through + 1
day are included in the plots, and the number of observations represented at
each point is shown below the figures. The curves represent the twenty-fifth,
fiftieth, and seventy-Gfth percentiles of the normalized standard deviation.
The normalization consists of dividing each firms implied standard deviation
at each observation date by the firms mean standard deviation over the
observation period. Hence, corresponding quartiles of the normalized stan-
dard deviations of the short and long options appear at roughly the same
level by construction. Since the firms may differ substantially in absolute

Fig. 6. Normalized standard deviations (quartiles), short options.

 J.M. Pate11 and M.A. Woljkon, Anticipated information in call options 129

:::L.- _\__
0.85 -

Fig. 7. Normalized standard deviations (quartiles), long options

level of variance, the normalization effects a cross-sectional scaling which

facilitates interpretation of the summary curves.1s
The graphs of the average standard deviations are similar to those implied
by the simple variance profile illustrated in figs. 1 and 2. Both groups of
options display a rising average standard deviation up to the date of the
earnings announcement, followed by a sharp drop. The visual correspon-
dence between the model in fig. 2 and the observations in figs. 6 and 7,
especially the decline at the announcement date, is consistent with the
hypothesis that the annual earnings announcement date is unticipated to be a
period of increased stock price variability. Note that the cross-sectional
sample standard deviation of the normalized implied stock price standard
deuiations (shown below the graphs) is markedly higher at the + 1 and +2

The normalization procedure is used strictly for visual presentation purposes and does not
enter into any of the tests of statistical significance.
130 J.M. Pate11 trnd M.A. Wolfson, Anticiputrd inform&ion in cull options

week observations. This may account for the erratic behavior of the graph
of the seventy-fifth percentile for the short options subsequent to the
disclosure period.
Table 2 contains the results of significance tests of the Zij comparisons for
both the short and long expiration options. Levels of significance for
probability values of less than 0.10 for both the Fisher signs tests and the
Wilcoxon signed ranks tests are presented. The tests measure the significance
of the positive changes in implied average standard deviations from -4
weeks to the earnings announcement, and the signiticance of the decline in
implied standard deviations following the disclosure. Results for the periods
- 1 day to 0, 0 to + 1 day, and the combined - 1 day to + 1 day period are
included.
The first row in each panel contains the ratio of the number of observed
positive differences to the total number of available observations. For
comparisons between -4 weeks and - 1 day (columns one through five) the
second row contains the probability (if less than 0.10) of obtaining a ratio
greater than or equal to the observed ratio under the null hypothesis that
positive and negative differences are equally likely. For comparisons between
- 1 day and + 1 day (columns six through eight), row two presents the
probability, under the null hypothesis, of obtaining a ratio less than that
observed. For the comparisons between + 1 day and +2 weeks (columns
nine and ten), two-tailed probabilities are computed. Row three contains the
corresponding significance levels obtained from the Wilcoxon test.
We had anticipated that the hypothesized pattern of average standard
deviations to expiration would be more pronounced in the short option
sample than for the longer options. The short option results reported in table
2 indicate that the predicted changes generally obtain and are statistically
significant. The Fisher or the Wilcoxon tests, or both, yield probability
values of less than 0.10 (less than 0.025 in the majority of the cases) for the
expected changes in the periods - 3 weeks to - 2 weeks, - 1 week to -2
days, -2 days to -1 day, -1 day to 0, 0 to fl day, and -1 day to $1
day. Particularly impressive are the increase and subsequent precipitous drop
in average standard deviation surrounding the announcement date. There
appears to be less thanha 0.005 probability that the declines observed from
the close at - 1 day to the close at + 1 day occurred by chance. Subsequent
to the announcement period, no significant average standard deviation
changes are observed.
As shown in fig. 7, the behavior of the long maturity options is also
consistent with the model, although in general, the noise in the data appears
to have overwhelmed any systematic changes in contiguous pairs of implied

The significance tests are based on a larger number of observations than the graphs since
only contiguous pairs of observations are necessary for the statistical tests, while we required a
complete set of observations from -4 weeks to + 1 day for the graphical presentation.
 Table 2
Fisher and Wilcoxon significance tests of consecutive changes in implied standard deviations of short and long options

Weeks (or days, d)

relative to $
announcement date i, j -4, -3 -3, -2 -2. -1 -1. -2d -Id, + Id +ld,+l +1, f2

Predicted sign of Z,, + + + + + _ _ _ 0 0

No. pos. 28 37 29 39 31 21 24 17 26 22
No. obs. 61 64 62 59 55 55 55 56 52 43

-w Short Fisher test

- options Significance level 0.007 0.040 0.002
if CO.10
M/ilcoxon test
Significance level 0.054 0.018 0.094 0.023 0.003
If <O.lO

No. pos. 19 29 22 21 23 I9 21 23 20 17
No. obs. 46 41 47 45 4: 44 44 43 4j 43

Long Fisher IL.SI

options Significance level 0.055
if CO.10
wucoxon test
Significance level 0.03 1
if ~0.10
132 J.M. Pate11 and M.A. Wol/k~n, Anticipated i~formution in call options

average variances. By transitivity, however, one would expect that certain off-
diagonal comparisons in fig. 5 would provide more powerful tests. Indeed,
for the long options, the growth in implied average standard deviation from
- 3 weeks to - 1 day is significant at the 0.032 level (Wilcoxon), and the
decline from - 1 day to + 1 week is significant at the 0.036 level (Fisher).
Other off-diagonal elements (not independent of the two noted above) are
also significant.
For purposes of comparison with other studies, table 3 provides the
distribution of undeflated average standard deviation (per year) estimates
from the Black-Scholes model for the firms included in figs. 6 and 7 at the
first observation date. When the common scaling induced by normalization
is eliminated, it is apparent that the implied standard deviations for the short
options generally exceed those for the long options.

6. Experimental testing details

The assumptions made by Black-Scholes to derive the closed form

solution to the option pricing problem include:

(1) The option price depends only upon the time to expiration and the
stock price, and the latter is assumed to follow a log-normal diffusion
process.
(2) There are no dividends over the life of the option contract.
(3) Capital markets are frictionless.
(4) The risk-free rate of interest is known and constant.
(5) The variance of the return to the underlying stock is constant over time.

6.1. Adjustment for dicidends

Black (1975, p. 41) has suggested an ad hoc approach to call valuation

when the underlying stock pays dividends during the life of the option:

If the option will be exercised only at maturity, we can approximate the

value of the option on a dividend paying stock by subtracting the
present value of the dividends likely to be paid before maturity from the
stock price. We use this adjusted stock price instead of the actual stock
price in the option formula.

Merton, Scholes and Gladstein (1978) use this approach, but substitute
actual dividends paid during the life of the option for expected dividends. We
employ the same technique. As Merton, Scholes, and Gladstein suggest, this

These two off-diagonal comparisons have not been reported in table 2.

In a thorough review article, Smith (1976) suggests that the Black-&holes analysis is
relatively insensitive to the (restrictive) assumptions made.
J.M. Putell und M.A. Wolfson, Anticipated information in cull options 133
134 J.M. Pufell und M.A. Wolfson, Anticipated informution in cull options

adjustment assumes that the dividends paid are escrowed at the date on
which the stock price is observed. To the extent that the future dividend is
uncertain in amount, this approach is not completely satisfactory, but no
obviously superior measurement has been proposed. A second potential
problem lies in the fact that the stock price may not decline by an amount
equal to lOOI/, of the dividend at the ex-dividend date, an assumption
implicitly made by the price adjustment procedure.
As discussed by Merton (1973) there is a positive probability of early
exercise when the underlying stock pays dividends. However, premature
exercise will only be optimal, if ever, immediately before the underlying stock
goes ex-dividend. Black (1975, pp. 41, 61, 72) suggests a second method for
dealing with the possibility of early exercise:

To figure the value of an option on a dividend-paying stock, we do two

calculations of the value, and use the one that gives the higher value.
The first calculation subtracts the present value of all the dividends from
the stock price, and uses the actual maturity date for the option. The
second calculation subtracts the present value of all dividends but the
last, and uses a maturity date just before the last ex-dividend date . .
(When there is a possibility that the option will be exercised before an
(earlier) ex-dividend date, we do calculations assuming expiration just
before every ex-dividend date, and use the one that gives the highest
value.)

When the objective is the computation of implied variance rates from

observed call prices, rather than the derivation of the appropriate call price
given an estimate of the variance rate, Blacks procedure implies that we
should select that maturity date which yields the Eon~est implied variance. To
see this, first note that there are at most D + 1 potentially optimal exercise
dates, where D represents the number of dividends to be paid between the
current date and the official expiration date. The current equilibrium price of
the option is its value assuming exercise at the most favorable date. If t* is
perceived to be the optimal exercise date, then the value of the option would
be lower if it were constrained to be exercised at any date other than t*.
Hence, for all candidate exercise dates other than t*, the call price used to
derive implied variances will be overstated. From the BlackKScholes va-
luation formula, we can see that X/&J >O, so the implied variances will also
be overstated. For all maturities except the one which yields the highest
value for the option, the implied variance rate will be biased upward to make
the observed call price appear to be an equilibrium price consistent with the

Roll (1977) explicitly considers this possibility in his &alysis of option valuation with
known dividends. However, Kalays (197X) evidence suggests that there is a dollar-for-dollar
tradeoff between dividends and price changes.
 J.M. Patell and M.A. Wolfson, Anticiputed information in cull options 135

BlackkScholes valuation formula. Therefore the lowest implied variance rate

corresponds to the correct exercise date.

6.2. Non-synchronous stock and optiorz price obsercutions

As discussed in section 4, closing option and stock prices are used to

compute implied standard deviations. For companies with very actively
traded stocks and options, the last daily trade for the stock is likely to be
very close in time to the last trade for the option. For less actively traded
issues, however, we face the problem that the last option trade may be thirty
minutes, an hour, or even longer before or after the last common stock trade.
If the equilibrium values of the securities change in the interim, we introduce
measurement error in the conlputation.0
In addition to the noise that this problem introduces into the tests, the
non-synchronous trading problem also leads to an upward bias in the
computation of implied standard deviations. The bias can be shown to
increase for deep in-the-money options. The bias can also be shown to
increase as the time to expiration decreases.
To illustrate the problem, suppose the final option trade for a particular
observation date precedes the final stock trade, and at the time of the final
option trade, the stock was trading at $80. Let the difference between the
stock price at the time of the last option trade and the price at the time of
the final stock trade be the realization from a simple branching process with
an equal chance of positive or negative 50$ moves. The stock pays no
dividends, the riskless rate is 5 percent, the exercise price of the option is $75,
and the standard deviation on the underlying stock is approximately 2.5
percent per year. Consider three different periods to expiration: 10 days, 25
days and 45 days.
One can see from table 4 that if the stock price rose, the implied average
standard deviation is underestimated, and if the stock price fell, the standard
deviation is overestimated. However, if the implied standard deviation is
computed to be negative, an apparent arbitrage profit opportunity exists and
the observation is discarded. In this manner, large underestimates of the
average standard deviation are removed while large overestimates remain.
Furthermore, as the example illustrates, the magnitude of the estimation
error, and thus the probability of illusory arbitrage profit opportunities,
increases as the time to maturity decreases. In an attempt to eliminate this

This problem would largely be eliminated by complete transactions data indexed by time of
trade.
ln-the-money options are those for which the underlying stocks price exceeds the exercise
price. Deep in-the-money options are those for which the stock price exceeds the exercise price
by a large amount. Deep out-of-the-money options are those for which the exercise price
exceeds the stock price by a large amount.
136 J.M. Parr/l and M.A. Wolfson, Anticipated infirmation in cull options

Table 4
The effects of non-synchronous price observations on implied standard deviations.

10 days to maturity 25 days to maturity 45 days to maturity

Stock Call Implied Call Implied Call Implied

price price std. dev. price std. dev. price std. dev.
_ ___.__~ _____
79.5 52, 0.4204 5$ 0.3195 6$ 0.2907
XO.Oh 5l% 0.2546 5; 0.2439 6$ 0.2441
x0.5 5 ih 52 61 O.IXO3

,A[ a stock price of X0.5 the implied standard deviation cannot be computed. Option is priced
as if arbitrage profit opportunities exist.
hPre\ailing stock price when the last option trade for the day was made.

problem, we excluded all observations for which the time to expiration was
less than or equal to 30 days.
A second problem related to non-synchronous price observations arises
when call prices are very low. Such options appear to trade very in-
frequently, largely due to the fact that changes in equilibrium option prices
of less than one-sixteenth of a dollar are no! reported. Since implied standard
deviations tend to be very sensitive to small changes in the value of such
options, a great deal of noise may be introduced by retaining very low-priced
options in the sample. As an ad hoc remedy, we restricted our observations
to those options trading at prices greater than or equal to $1. We conducted
a replication of the empirical tests using a 50$ option price cut-off, which
resulted in a 10 percent to 20 percent (5 percent to 15 percent) increase in
sample size for the short (long) options. The results obtained were entirely
consistent with those reported in the previous section.

The implied standard deviations for the various available exercise prices
were arithmetically averaged separately for each firm at each observation
date. LatanC and Rendleman suggest that some options are more dependent
upon a precise specification of the standard deviation than others, and use a
weighted average implied standard deviation in which the implied standard
deviations for all options on a given underlying stock are weighted by the
partial derivative of the BlackkScholes equation with respect to each implied
standard deviation (1976, p. 371). The Latan&Rendleman procedure puts
little weight on options which are either deep in the money or deep out of
the money. In tests of the predictive ability of implied standard deviations,
Beckers (1978) found that the Latant:-Rendleman procedure was not super-
ior to using the estimate obtained from the single most sensitive option,
typically the at-the-money option. We replicated our analyses restricting
 J.M. Pate11 and M.A. Wo&m, .4nticiputrd infbrmation in cull options 137

attention to the single option whose exercise price was closest to the firms
stock price (at-the-money) and again obtained results consistent with those in
section 5.
Previous studies [e.g., Black (1975) and Thorp (1976)] express some
uncertainty as to the most appropriate empirical time series of the term
structure of risk-free rates. Thorp argues that the proper discount rate may
be closer to a risk-free borrowing rate, which in general exceeds Treasury Bill
rates. For the tests reported in section 5, we used weekly Treasury Bill rates
including five different maturities. To investigate the sensitivity of our results
to different discount rate proxies, we replicated the tests under two alter-
native risk-free rate specifications. First, we retained the underlying Treasury
Bill term structure, but altered the level of the time series by incrementing
each element by a constant number of basis points. Replications were
conducted in which the level was raised by 25, 50, 100, and 200 basis points.
Second, we replaced the Treasury Bill rate series altogether with a new time
series consisting of weekly Commercial Paper rates of three different matu-
rities.22 In general, our inferences remain unchanged and. in fact. the use of
Commercial Paper rates yielded somewhat sharper results, as indicated in
table 5.

7. Summary and conclusions

We began with a simple model in which market participants expect the

date of an information disclosure to be a period of temporarily increased
stock price variability. Such behavior was shown to imply systematic changes
in the standard deviations derived from call option prices via the Black
Scholes options pricing formula. The statistically significant changes in
implied standard deviations which we observed are consistent with this
model.
Prices of options with short periods to expiration apparently reflect the
anticipation of a temporary increase in stock price variability due to the
expected release of annual earnings numbers. This anticipation is evidenced
by steadily increasing implied average standard deviations from four weeks
prior to the announcement date to the date of the announcement, and a
dramatic decline in implied average standard deviations in the two-day
announcement period. The changes in implied standard deviations for longer
options are less pronounced due to the greater length of the averaging
period, although statistically significant results do obtain.
In addition to providing support for the anticipated information content of
annual earnings announcements, our analysis is relevant to the prediction of
stock price variability. Our model suggests that .s~~.srematic changes in
variability occur at the dates of anticipated information releases, many of
Rates were obtained from Bank awl Quotatum Record.
138 J.M. Patell and M.A. Wo&m, Anticipated infiwmution in cull options
which are seasonal in nature. An immediate implication is that care must be
taken in aggregating implied variance estimates from options of different
maturities.
A natural extension of this study is the investigation of the anticipated
information content of quarterly earnings and dividend announcements. The
relative magnitudes of the expected effects of quarterly and annual earnings
announcements could be considered.23* 24 The empirical domain of infor-
mation events which might affect the variability of stock prices at known
points in time need not be confined to earnings announcements, either
annual or quarterly. One might also consider the effects of the release of
economic indicators: consumer and wholesale price indices, quarterly trade
statistics, presidential election results, etc. We believe that a complete record
of transactions data, which would overcome the non-synchronous trading
problem, would increase the power of our tests. Such data would be
particularly useful in addressing speed of adjustment questions. These issues
are indicative of a broad class of problems for which option prices may
prove to be particularly useful.

Z3Such an investigation would require a precise specification of the proper scaling techniques
for implied variances necessary to conduct comparative tests.
This paper was first presented at the Stanford Accounting Research Seminar (July, 1978). At
that time we were informed that George Foster (now at Stanford University) and Jonathan
Ingersoll (University of Chicago) were in the process of conducting empirical tests similar in
many respects to the tests reported here.

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