Volatility Arbitrage around Earnings Announcements:

Evidence from the Korean Equity Linked Warrants Market

Bok Baik, Hyoung-Goo Kang and Young Jun Kim

4.9.2013

ELW News Headlines

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

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
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.
4

The Equity Linked Warrants (ELWs)

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
2006
2007
2008
2009
2010

72
1,387
1,646
2,613
4,367
9,063

23
66
71
77
106
110

662
3,826
4,843
4,415
7,286
23,789

478.2%
26.6%
-8.8%
65.0%
226.5%

21
185
276
385
852
1,637

0.4%
5.4%
5.0%
7.4%
14.7%
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:

Exclude financial industry

Exclude ELWs that are not traded for more than 10 days during the 21-day interval
Panel B: ELWs with non-missing price observation in
[-10,+10]

Panel A: All Call ELWs

ELW (#)
20,949

Observations Underlying
(#)
stocks (#)
1,970,915

LP are exempt from liquidity provision requirements

119

ELW (#)
5,166

Observations Underlying
(#)
stocks (#)
108,486

94

Panel C: ELWs satisfying selection criteria

in [-10,+10]

Events (#)

ELW (#)

281

2,461

Observations Underlying
(#)
stocks (#)
51,681

88

Events (#)
262
6

Top (Bottom) 10 Underlying Stocks After screening

with the Largest (Least) Number of ELWs Traded around Earnings Announcements
Top 10

Bottom 10

Rank

Underlying
Stock

2005

2006

2007

2008

2009

Total

Percent

Rank

Underlying
Stock

Total

Percent

Samsung
Electronics

36

63

44

69

221

8.98%

79

Hite holdings

0.04%

Hynix
Hyundai
Motors
LG
Electronics

30

53

28

53

168

6.83%

80
81

Orion
KCC

1
1

0.04%
0.04%

26

46

33

51

162

6.58%

82

Amorepacific

0.04%

20

24

29

54

130

5.28%
83

0.04%

LG Display

17

32

26

42

120

4.88%

Samsung Fine
Chemicals

POSCO

23

31

37

101

4.10%

84

Hansol Paper

0.04%

KIA Motors

13

12

41

77

3.13%

85

Poongsan
Corporation

0.04%

0.04%

0.04%

LG Household
& Health Care

0.04%

Subtotal
Total

10
2461

0.37%
100.00%

2
3
4

9
10

Samsung
Heavy
Industries
Hyundai
Heavy
Industries
SK
Telecom
Subtotal
Total

14

19

21

21

76

3.09%
86

18

21

22

71

2.89%

87

17

13

33

70

2.84%

88

34

173

308

258

423

1196

51

330

590

498

992

2461

48.60%
100.00
%

Hyundai
Hysco
SBS

Period: 2005.12.1~2010.6.30
7

Average Implied Volatility around Earnings Announcements

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

Comparison of Implied Volatility Before and After the Earnings Announcement

Days
T1: T2

Average of

Median of

% of events where
<0

- 1:0
0:+1
-10:+10
-9:+9
-8:+8
-7:+7
-6:+6
-5:+5
-4:+4
-3:+3
-2:+2
-1:+1

-0.0002
-0.0063
-0.0348***
-0.0162*
-0.0149***
-0.0182**
-0.0163**
-0.0120*
-0.0039
-0.0030
-0.0123**
-0.0065

-0.0005
-0.0017***
-0.0276***
-0.0182***
-0.0142***
-0.0169***
-0.0139***
-0.0084***
-0.0067***
-0.0050***
-0.0079***
-0.0036***

47.0%
48.5%
57.9%
54.6%
54.6%
55.9%
54.3%
52.1%
50.9%
50.1%
52.9%
49.9%

10

Subsequent Question

Can certain market players take advantage of these opportunities?

11

Volatility Arbitrage Trading Strategy

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

=0

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
12

Trading Profit across Various Window Sizes

Trading
Period
[-10,+10]

Mean

2461

11.40%

[-9,9]

2461

[-8,8]

Std Dev

Min

1%

5%

10%

25%

50%

75%

90%

95%

99%

Max

28.30% -377.60% -52.10% -16.40%

-7.60%

1.80%

10.40%

20.90%

34.10%

43.70%

65.90% 546.20%

9.80%

29.40% -259.10% -50.30% -18.90%

-9.20%

0.20%

8.50%

18.70%

31.60%

41.00%

64.40% 773.30%

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%

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

13

Trading Profit by Moneyness and Maturity

Mean Trading Profit

Short term: 30 < m 60 days

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

Median Trading Profit

Mny = 1-K/(St-PVDt )
Mny -0.09 (Deep OTM)
-0.09<Mny -0.03 (OTM)
0.03<Mny 0.03 (ATM)
0.03<Mny 0.09 (ITM)
0.09<Mny
(Deep ITM)

ST Deep OTM ELWs deliver a average(median) 26.0%(23.8%) trading profit per ELW contract
14

Trading Profit by Moneyness and Maturity

Moneyness

Mean

Median

Std Dev

Deep OTM

1353

15.70%

13.70%

33.00%

OTM

329

6.40%

9.10%

29.00%

ATM

283

6.20%

8.30%

16.20%

ITM

254

6.10%

6.70%

Moneyness

Deep OTM

OTM

16.60%

ATM
Deep ITM
ST

Maturity

MT

242
593
1259

6.30%
18.30%
10.50%

5.50%
16.10%
10.60%

10.80%
44.10%

ITM

22.70%

Deep ITM
LT

609

6.60%

6.80%

14.80%

Maturity

Mean

Median

Std Dev

ST

326

26.00%

23.80%

51.90%

MT

680

14.60%

14.10%

26.20%

LT

347

8.10%

8.40%

14.90%

ST

83

10.30%

16.10%

45.20%

MT

168

5.60%

8.00%

20.20%

LT

78

3.90%

6.40%

22.20%

ST

69

8.00%

10.90%

21.60%

MT

153

6.00%

8.40%

14.70%

LT

61

4.70%

5.30%

12.20%

ST

68

9.00%

10.60%

19.40%

MT

128

5.00%

6.00%

17.50%

LT

58

5.20%

5.60%

9.40%

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

15

Robustness Test
Trading Profit in [-10,10] by Liquidity
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%

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

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%

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

16

Conclusion

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

17