Information Embedded in Option Prices: Evidence from Credit Rating Agency Announcements

Abstract

We employ the implied volatility spread (IVS) as a measure of the information content of options, and confirm that IVS has the ability to predict future daily stock returns. We then focus on credit rating announcements and find that IVS has significantly higher predictive power on event days versus non-event days. In a consistent set of results we find that IVS predicts the direction and magnitude of credit rating changes. Exploring the source(s) of this predictability we argue it is driven primarily by short-sale activities. We find evidence against the hypotheses that IVS predictive power is driven by informed trading in options or by liquidity effects. These findings suggest that traders with information about credit rating announcements prefer to trade in the short-sale market rather than the options market.