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Article summary:
1. The volatility smirk is a stylized fact that implies the implied volatility of low strike price options (especially out-of-the-money, or OTM, put options) is higher than that of high strike price options (especially at-the-money, or ATM, call options).
2. This paper examines the relation between financial reporting opacity and ex ante (or perceived) crash risk, as reflected in the steepness of implied volatility smirks.
3. The study finds that earnings management, financial statement restatements and auditor-attested material internal control weakness are all positively associated with the steepness of the implied volatility smirk.
Article analysis:
The article provides a comprehensive overview of the literature on financial reporting opacity and its relation to expected crash risk as reflected in the steepness of implied volatility smirks. The authors provide evidence from prior research to support their argument that financial reporting opacity increases stock price crash risk due to managers’ incentives for withholding bad news from investors. They then present three firm-level proxies for financial reporting opacity – earnings management, financial statement restatements and auditor-attested material internal control weakness – which they use to test their hypothesis.
The article is generally reliable and trustworthy in its presentation of evidence and arguments. It provides a thorough review of relevant literature and presents empirical evidence to support its claims. The authors also take care to control for various firm characteristics and stock/option trading variables when testing their hypothesis, which helps reduce potential biases in their results.
However, there are some potential sources of bias that should be noted. First, the authors rely heavily on OptionMetrics data for 1996–2008 for their analysis; this may not be representative of more recent trends in option pricing behavior or other market conditions that could affect their results. Second, while they do control for various firm characteristics when testing their hypothesis, it is possible that there are other factors not accounted for which could influence the results; further research should explore these potential confounding variables more thoroughly. Finally, while they do discuss some counterarguments to their hypothesis (such as limits to arbitrage), they do not explore them in depth; further research should consider these arguments more carefully before drawing any conclusions about the effects of financial reporting opacity on expected crash risk.