Bok Baik, Hyoung-Goo Kang and Young Jun Kim

4.9.2013

Volatility Arbitrage around Earnings Announcements:

Evidence from the Korean Equity Linked Warrants Market

ELW News Headlines

2

Put ELW yields 4,000% return for two days Money Today 2011.08.03

Massive speculations in the ELW market. Institutional investors win big while individuals

lose fortunes. Hankyoreh 2010.10.22

Financial Supervisory Commission to require sufficient training for ELW trading.

Money Today 2010.10.31

Regulators crack down on the ELW market. KRW 15 million balance requisite for

investors, limitations on scalpers, and rigorous issue standards.

Maeil Business 2011.05.19

Research Questions

3

1. Is there any predictable pattern of movements in the implied volatility of ELWs

around earnings announcements?

2. If so, can certain market players take advantage of these opportunities?

Literature Review

4

The impact of Events or News on the Implied volatility

Scheduled firm-specific news

Earnings announcements

Patell and Wolfson(1979,1981), Donders and Vorst(1996)

IV increases significantly before earnings announcements and drop afterwards

Management forecasts

Rogers, Skinner and VanBuskirk (2009)

IV increases after management forecasts (irregular and bad news)

Unscheduled firm-specific news

Mergers and Acquisitions

Levy and Yoder(1993)

IV of target firms increase significantly three days before the announcement.

IV of the bidding firm are not affected.

The Equity Linked Warrants (ELWs)

5

Introduced on 12/01/2005

The world's second largest after Hong Kong

Similar payoff to options payoff, but legally stock, not derivative

Underlying asset: stocks in KOSPI100, 5 large cap stocks in KOSDAQ, Indices

Issued by the securities firms

Liquidity Provider(LP) at least one liquidity provider should be assigned to each ELW

duty of offering a bid-ask price every 5 min

Year

No. of

listed ELWs

No. of

underlying

assets

Market cap

(KRW billion)

Market cap

growth rate

Average daily

trading value

(KRW billion)

Average trading

value

of the ELW

market

compared to

the KOSPI

2005 72 23 662 21 0.4%

2006 1,387 66 3,826 478.2% 185 5.4%

2007 1,646 71 4,843 26.6% 276 5.0%

2008 2,613 77 4,415 -8.8% 385 7.4%

2009 4,367 106 7,286 65.0% 852 14.7%

2010 9,063 110 23,789 226.5% 1,637 29.2%

Sample

Period: 12/01/2005 ~ 06/30/2010

ELW: KOSCOM

Earnings Announcement Date: Disclosure system, maintained by KRX

Stock price: Data Guide

Sample Selection Criteria

European Call ELW ( 91.3% of total ELWs written on individual stocks)

Non-missing during the 21-day interval

Time-to-Maturity > 30 Days: LP are exempt from liquidity provision requirements

ELW Price > KRW 10: LP are exempt from liquidity provision requirements

Exclude financial industry

Exclude ELWs that are not traded for more than 10 days during the 21-day interval

6

Panel A: All Call ELWs Panel B: ELWs with non-missing price observation in

[-10,+10]

Panel C: ELWs satisfying selection criteria

in [-10,+10]

ELW (#) Observations

(#)

Underlying

stocks (#) ELW (#)

Observations

(#)

Underlying

stocks (#) Events (#) ELW (#)

Observations

(#)

Underlying

stocks (#) Events (#)

20,949 1,970,915 119 5,166 108,486 94 281 2,461 51,681 88 262

Top (Bottom) 10 Underlying Stocks After screening with the Largest (Least) Number of ELWs Traded around Earnings Announcements

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Rank Underlying

Stock 2005 2006 2007 2008 2009 Total Percent

1 Samsung

Electronics 9 36 63 44 69 221 8.98%

2 Hynix 4 30 53 28 53 168 6.83%

3 Hyundai

Motors 6 26 46 33 51 162 6.58%

4 LG

Electronics 3 20 24 29 54 130 5.28%

5 LG Display 3 17 32 26 42 120 4.88%

6 POSCO 3 7 23 31 37 101 4.10%

7 KIA Motors 2 9 13 12 41 77 3.13%

8

Samsung

Heavy

Industries

1 14 19 21 21 76 3.09%

9

Hyundai

Heavy

Industries

3 7 18 21 22 71 2.89%

10 SK

Telecom 0 7 17 13 33 70 2.84%

Subtotal 34 173 308 258 423 1196 48.60%

Total 51 330 590 498 992 2461 100.00

%

Rank Underlying

Stock Total Percent

79 Hite holdings 1 0.04%

80 Orion 1 0.04%

81 KCC 1 0.04%

82 Amorepacific 1 0.04%

83 Samsung Fine

Chemicals 1 0.04%

84 Hansol Paper 1 0.04%

85 Poongsan

Corporation 1 0.04%

86 Hyundai

Hysco 1 0.04%

87 SBS 1 0.04%

88 LG Household

& Health Care 1 0.04%

Subtotal 10 0.37%

Total 2461 100.00%

Top 10 Bottom 10

Period: 2005.12.1~2010.6.30

Average Implied Volatility around Earnings Announcements

8

Liquidity weighted average of implied volatility per underlying stock Group ELWs by each underlying stock each year and calculate a weighted average implied volatility

based on ELW trading volume

Top 50% (25%) liquid subsample ELWs with total trading volume in the top 50 (25) percentile over the event period

Implied volatility tends to decrease around earnings announcement

Abnormal Trading Volume around Earnings Announcements

9

Comparison of Implied Volatility Before and After the Earnings Announcement

10

Days

T1: T2

Average of

Median of % of events where

< 0

- 1:0 -0.0002 -0.0005 47.0%

0:+1 -0.0063 -0.0017*** 48.5%

-10:+10 -0.0348*** -0.0276*** 57.9%

-9:+9 -0.0162* -0.0182*** 54.6%

-8:+8 -0.0149*** -0.0142*** 54.6%

-7:+7 -0.0182** -0.0169*** 55.9%

-6:+6 -0.0163** -0.0139*** 54.3%

-5:+5 -0.0120* -0.0084*** 52.1%

-4:+4 -0.0039 -0.0067*** 50.9%

-3:+3 -0.0030 -0.0050*** 50.1%

-2:+2 -0.0123** -0.0079*** 52.9%

-1:+1 -0.0065 -0.0036*** 49.9%

Subsequent Question

11

Can certain market players take advantage of these opportunities?

Volatility Arbitrage Trading Strategy

12

Volatility Arbitrage Trading Strategy:

Delta-neutral short position (short volatility position)

Neutralize the small changes in underlying stocks and bet on the decrease of the ELWs

implied volatility

Construct a delta neutral portfolio 10 days before announcement and liquidate the position

10 days after announcement

Delta Neutral Portfolio

The portfolio value remains unchanged due to small changes in the value of the underlying

security.

Sell ELW and buy # of stocks by using ELW sale proceeds and borrowing/depositing

bonds and rebalance it everyday

Zero-investment portfolio V(0)=0

= 0

Trading Profit across Various Window Sizes

13

Assumptions

Trading cost of buying stocks =0.1% Trading cost of selling stocks =0.4% =0.1% + 0.3%(Tax)

Trading cost of buying ELW =0.1% Trading cost of selling ELW =0.1% (No Tax)

Our trading strategy generates a sizable profit of 11.40 % for 21 days

Trading

Period

N Mean Std Dev Min 1% 5% 10% 25% 50% 75% 90% 95% 99% Max

[-10,+10] 2461 11.40% 28.30% -377.60% -52.10% -16.40% -7.60% 1.80% 10.40% 20.90% 34.10% 43.70% 65.90% 546.20%

[-9,9] 2461 9.80% 29.40% -259.10% -50.30% -18.90% -9.20% 0.20% 8.50% 18.70% 31.60% 41.00% 64.40% 773.30%

[-8,8] 2461 9.10% 23.90% -405.40% -51.50% -17.90% -8.90% 0.20% 8.00% 17.60% 31.00% 40.70% 65.30% 253.60%

[-7,7] 2461 8.90% 22.60% -183.20% -46.00% -17.00% -8.90% -0.30% 7.20% 16.40% 28.80% 39.90% 74.80% 330.20%

[-6,6] 2461 8.00% 20.60% -156.90% -40.30% -15.90% -8.70% -0.80% 6.10% 14.60% 27.70% 37.70% 64.30% 281.20%

[-5,5] 2461 6.10% 22.80% -366.20% -40.10% -16.00% -9.40% -2.50% 4.80% 12.20% 23.70% 34.10% 59.50% 441.10%

[-4.4] 2461 3.70% 19.30% -196.90% -41.30% -19.20% -11.10% -3.50% 2.70% 9.70% 19.50% 27.30% 50.50% 376.70%

[-3,3] 2461 1.90% 18.40% -302.80% -48.80% -21.40% -13.10% -4.40% 1.70% 8.70% 18.30% 26.80% 47.60% 180.30%

[-2,2] 2461 1.70% 16.50% -265.50% -47.20% -18.50% -12.10% -4.20% 1.10% 7.80% 16.70% 24.20% 42.80% 175.50%

[-1,1] 2461 -0.80% 14.50% -163.60% -44.80% -19.80% -12.80% -5.70% -0.60% 4.60% 12.00% 18.40% 36.40% 112.80%

Trading Profit by Moneyness and Maturity

14

Mean Trading Profit Median Trading Profit

Short term: 30 < m 60 days Medium term:60< m 120 days Long term: m >120 days

Mny = 1-K/(St-PVDt )

Mny -0.09 (Deep OTM) -0.09

Trading Profit by Moneyness and Maturity

15

Moneyness Maturity N Mean Median Std Dev

Deep OTM

ST 326 26.00% 23.80% 51.90%

MT 680 14.60% 14.10% 26.20%

LT 347 8.10% 8.40% 14.90%

OTM

ST 83 10.30% 16.10% 45.20%

MT 168 5.60% 8.00% 20.20%

LT 78 3.90% 6.40% 22.20%

ATM

ST 69 8.00% 10.90% 21.60%

MT 153 6.00% 8.40% 14.70%

LT 61 4.70% 5.30% 12.20%

ITM

ST 68 9.00% 10.60% 19.40%

MT 128 5.00% 6.00% 17.50%

LT 58 5.20% 5.60% 9.40%

Deep ITM

ST 47 7.70% 7.80% 12.50%

MT 130 6.40% 4.90% 11.60%

LT 65 4.90% 4.30% 7.30%

ST > MT > LT Deep OTM > Other Moneyness

N Mean Median Std Dev

Deep OTM 1353 15.70% 13.70% 33.00%

Moneyness OTM 329 6.40% 9.10% 29.00%

ATM 283 6.20% 8.30% 16.20%

ITM 254 6.10% 6.70% 16.60%

Deep ITM 242 6.30% 5.50% 10.80%

ST 593 18.30% 16.10% 44.10%

Maturity MT 1259 10.50% 10.60% 22.70%

LT 609 6.60% 6.80% 14.80%

Robustness Test

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N Mean Std Dev Min 1% 5% 10% 25% 50% 75% 90% 95% 99% Max

Full

sample 2461 11.4% 28.3% -377.6% -52.1% -16.4% -7.6% 1.8% 10.4% 20.9% 34.1% 43.7% 65.9% 546.2%

Top

50% 1231 9.4% 27.7% -377.6% -52.1% -16.4% -7.6% 1.6% 9.1% 18.0% 29.6% 37.1% 51.9% 546.2%

Top

25% 616 9.4% 32.4% -377.6% -49.2% -16.0% -6.6% 2.1% 8.7% 17.3% 27.2% 35.9% 50.7% 546.2%

N Mean Std Dev Min 1% 5% 10% 25% 50% 75% 90% 95% 99% Max

Normal

TC 2461 11.4% 28.3% -377.6% -52.1% -16.4% -7.6% 1.8% 10.4% 20.9% 34.1% 43.7% 65.9% 546.2%

High TC 2461 9.4% 28.5% -393.5% -54.5% -19.3% -9.7% 0.0% 8.4% 19.1% 32.9% 42.4% 63.8% 532.0%

Trading Profit in [-10,10] by Liquidity

Trading Profit in [-10,10] and Transaction Cost

Normal TC:40 bps per unit for stock sale and 10 bps per unit for stock purchase and ELW trading

High TC:80 bps per unit for stock sale and 50 bps per unit for stock purchase and ELW trading

Small reduction in trading profit

Conclusion

17

Implied volatilities in the Korean ELW market tend to decrease before EA

LPs face advantageous trading opportunities around EA

-In particular, short-term deep out-of-the-money ELWs deliver a 26.0% trading profit

-The Korean ELW market does not seem to be a level playing field