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1/ BACKGROUND In finance theories, the researchers tend to make the assumptions of the homogeneity for investors when they derive a certain model or a formula, which means that under given set of circumstances, they assume that the investor will want the same thing. For example, in the modern portfolio theory, the investors are assumed to choose the assets with the highest returns at a given level of risk, and choose the assets with the lowest risk at a given the same level of return. Under homogeneous beliefs or common beliefs assumption, all investors are believed to have identical expectations with respect to the necessary inputs to the portfolio decision. These inputs are expected returns, the variance of returns, and the correlation matrix. However, it is argued that this assumption does not hold entirely true and sometimes are unrealistic. Consequently, the explanation of some financial models or formulas is of limited practical value. In a dynamic market, the investors are believed to be different from each other in terms of risk tolerance, the beliefs and time preferences. And this difference in belief or heterogeneity does reflect a better operation of the market in which market participants are not consistently rational as assumed by the theoretical models. Now if the homogeneity assumption is not realistic, one question that needs to be raised is that: In which way can we realize the existence of difference in belief among the market participants? And if the difference does really exist, what factors will represent for it? And how do these factors influence the implied volatility smile?

Finding out the answer for these questions would help to develop a better understanding of the stock market because of following reasons: Firstly, it is believed that it is the disagreement among investors that increases the stock trading volume. In fact, in a market in which there are both pessimistic and optimistic investors, the stock will be traded more frequently among these market participants. For example, there would be a time when the optimists, i.e. optimistic

investors, find the stock which is currently being underpriced and believe it could outperform the market in the near term future, then they are willing to buy the stocks from the pessimists who have a different view on the prospects of that particular stocks. Secondly, several studied have shown that there is a relationship between stock returns and investor disagreement. The investor disagreement occurs simply because the uncertainty about the future payoffs of stock returns increases. For that reason, some researchers suggest that investor disagreement could be considered as a source of risk, and they refer this source of risk to nonfundamental risk. The risk arising from greater uncertainty in the market would therefore deter investors from holding the stocks unless they are adequately compensated with a premium for this type of risk. In other words, not only would greater investor disagreement affect the risk level, it would also drive the level of return higher to compensate the investors in the context of an uncertain market. Therefore, recognizing assets, e.g. stock, bonds, that are having high divergence of opinion among investors would help the analysts, to some extent, predict or analyse the return of that particular asset. In the option pricing theory, the different or so-called divergent or heterogeneous beliefs of investors can be seen through examining the option prices of that underlying stock. To be more specific, it is seen that the volatility of the stock implied from the market price of the option for a certain period when plotted against the strike price of the option will be different and shows the smile. This smile effect of volatility reveals the difference in the expectation or the belief of the investor towards the movement of the stocks. Shefrin (1999) suggest that the optimistic investors will push the price of out-of-money call option up, whereas the pessimistic investors will push the price of out-of-money put option up. The difference in belief or expectation of the market is due to the difference in interpretation of information relevant to the stocks and such a divergent opinion would affect both the asset prices and option prices. Whereas historical volatilities are backward looking, implied volatilities are forward looking. The implied volatility is the volatility level, when plugged into the Black-Scholes formula, would make option price equal the options observed market

price. The U-shaped variation in the implied volatility across different strike prices is called the volatility smile. The implied volatility tends to depend on its strike price and time-to-maturity. Recent studies have shown that the implied volatility smile is associated with the belief differences of investors. John Hull (2000) suggests that implied volatilities can be used to monitor the markets opinion about the volatility of a particular stock. Shefrin (1999) shows that the log-pricing kernel can be divided into two parts, one is from the fundamentals and the other is from the investor sentiment. According to him, the prices are efficient only when the sentiment part is zero, and when the sentiment is nonzero, it would lead to the smile effect in option prices. Buraschi and Jilshov (2006) discover that the dividend growth rate is the factor that analysts tend to have more divergent opinions and the heterogeneous expectation of dividend growth rate affect option prices and produce a volatility smile. The model of two authors shows that the optimistic investors demand out-of-money call options, whereas pessimistic investors demand out-of-money put options. 2/ MOTIVATION OF THE STUDY Most of existing papers relating to the options market have used the options written on the US companies rather than UK companies. This is perhaps because the options market in the US is the most developed market with a great number of market participants, which has helped to create more efficiency for the market and at the same time helped to facilitate researchers to retrieve the data for options. In fact, it is easy to see that the data for options from most of studies in the field of options market was taken from Chicago Board Options Exchange. Very few studies have tested theories using options written on listed firms on the London Stock Exchange (LSE). This project will be one of those few studies to use the sample of only listed firms on the LSE, known as plc, to study the theory relating to options. Another contribution of this project is that the studies will only focus on empirically examining the option implied volatility smile in connection with proxies for investor belief rather than using many other variables used in previous studies, e.g. beta , put to call ratios, net buying pressure

And finally, the data for options will be the cross sectional data rather than the time series data. This issue will be elaborated more in the methodology part. 3/ OBJECTIVE OF THE PROJECT This paper aims to empirically examine the effect that the divergence of opinion of investors have on the option implied volatility smile through testing the hypothesis about relationships between the proxies for investor belief and call slopes and put slopes estimated from the option prices. The idea of the project is that if option price are truly influenced by the divergence of investor belief, then the smile of implied volatility will be more pronounced for underlying stocks which have greater divergence in investors belief. Even though the belief differences or heterogeneity are not directly observable, based on the previous results this paper identifies six widely used proxies for heterogeneity in beliefs among investors. Following that, for each proxy of divergence of opinion, the paper would provide the literature to support the development of the hypothesis describing the relationship between option implied volatility smile and that particular proxy. The empirical research would, therefore, aim to test whether the hypothesis still holds given the data of option prices and data representing the proxy that is retrieved at a specific point in time. Previous papers suggest that the stocks with higher difference in earnings forecast made by analysts tends to have more pronounced volatility smile. The heterogeneous beliefs are also reflected through the high trading volume of underlying stocks. The high open interest of options is also seen as an indication of high belief divergences. Moreover, stocks with high price to earnings ratio or low earnings yield, and stocks of smaller firm would also be suggested to induce greater divergence in expectations among investors, and thus their implied volatility from the options have a more pronounced smile shape. These five proxies for heterogeneity that have effect on option prices would be empirically examined in this paper through six hypotheses using the data of option prices and other secondary data of the underlying stocks.

4/ STRUCTURE OF THE PROJECT Based on those ideas, the structure of will be broken down into following sections: Section 1: This section is divided into two parts: Part A: presents the background on following issues, namely: a/ properties of options, b/ implied volatility, c/ the explanations for the volatility smile phenomenon and d/ divergence of investor beliefs. Part B: presents the findings of a/ the relations between implied volatility smile and divergence of investor beliefs and b/ findings of the determinants of implied volatility smile. Section 2: This section looks at the background of factors widely used for heterogeneous beliefs followed by the hypotheses detailing the relations between a particular proxy and implied volatility smile slope. Section 3: This section describes a/ the sample data for underlying firms and their stock options and b/ the methodology applied to answer for the research questions and the approach to analyse the data. Section 4: This section presents and critically discusses the results Section 5: Recommendation and conclusion. To make it easy to follow, throughout the report the term investor disagreement would be used interchangeably with other terms, namely: divergence of opinion, heterogeneity in beliefs, investors heterogeneous beliefs, investors divergent beliefs.



PART A 1/ A REVIEW OF STOCK OPTIONS Stock call option is a contract giving the buyers, who take the long position, the right to buy one underlying stock from the seller, who take the short position, at a specific price on or before a certain day in the future. Call options are exercised when the underlying share price (St) proves to be equal or greater than the strike price (K). Therefore, the higher the strike price, the cheaper the call option price (c) and vice versa. Stock put option is opposite to call options, it gives the buyers the right to sell one underlying stock at a predetermined price at or before the maturity date. Put options are exercised when the underlying share price proves to be equal or lower than the strike price. Therefore, the lower the strike price, the cheaper the put option price (p) and vice versa. There are often three types of options that the market mentions about: Out of money (OTM) is when the exercise price is greater than the underlying share price for a call (Kcall > S), and when the exercise price is lower than the underlying share price for a put (Kput < S). OTM options will expire worthless if it expires today. In the money (ITM) is the reverse of OTM options, ITM call option is OTM put option and vice versa. ITM does not guarantee a profit for the buyer it only means the option is worth exercising. At the money (ATM) for both put and call options is when the exercise price is equal to the underlying share price. (Kcall = Kput = S) 2/ IMPLIED VOLATILITY Volatility of the underlying share (i) is the only unobservable variable in the Black Scholes formula, and yet it can be derived from observation of option prices on the market by plugging other observable variables, i.e. stock price, strike price, time to expiration and risk free rate, into the formula. Now if the market is assumed to be efficient and the Black Scholes model is valid, then the implied volatility should be an

unbiased predictor of the future actual volatility of the underlying share price over the remainder of option life. Rendleman (1976), for example, concluded after examining implied volatility of the sample of 24 firms on the Chicago Board Options Exchange that the implied volatility forecasts the future volatility of the stock better than the historical volatility. Of course, there have been many option pricing models devised in the past and therefore the implied volatility estimated from these models would not match with one another perfectly and there also have been many doubts about the efficiency of the market. However, implied volatility from the option price does reflect the expectation of the market to the future movement of the underlying stocks. 3/ WHY DOES THE OPTION IMPLIED VOLATILITY SMILE? The existence of the smile of volatility have been studied and empirically observed throughout the development of options market. One typical example is the existence of trading opportunity in the options market during mid-1980s. Even though this opportunity exists in the currency options, they can be seen as an example to justify the existence of the option implied volatility smile. It was in mid-1980s that some of the traders decided to buy far OTM call and put options on a variety of different currencies and just wait. Their strategy did prove to be successful since many of the deep OTM options they bought expired in the money. The reason for their success invalidates the lognormal assumption of Black Scholes model. In fact, at that time these OTM options are valued using the same volatility instead of volatility smile and thus their market prices are relatively low. Also, given the arbitrage argument in options, Chiras and Manaster (2001) tested to see whether it is realistic to make abnormal returns in trading options on the CBOE market. They bought the options with low implied volatility and sell the option with high implied volatility. The strategy showed an abnormal profit of 10%, which suggests that the CBOE market was inefficient in some respects. Since then, several explanations for the smile effect have been put forward. The most common and probably most sensible reason for the occurrence smile is due to the empirical violations of normal distribution assumption of stock returns. In his model of finding the price of the option, Black and Scholes make several assumptions about the stock price movement, and one of them is the normal

distribution of the stock return and assumption of the lognormal distribution of stock price. In effect, they assume that the probability of occurrence of extreme returns is very low and the return is normally distributed. Therefore, the volatility implied from the theoretical option price should be constant, flat and unchanged over a certain period of time. However, many studies pointed out that that assumption is not realistic since in reality the distribution of stock returns is not perfectly normal but skewed and exhibit fat tails. Statistically, a normal distribution should have the skewness of 0 and Kurtosis of 3 (Bulmer, 1965). The skewness of the distribution of stock returns can be positive or negative. When the skewness is positive the shape of the distribution is skewed to the right (left), revealing a higher probability of earning higher (lower) return than the probability in a normal distribution. Bakshi (2003) tested the distribution of stock returns on the CBOE and found that more than half of stocks exhibited the slightly positive skewness. He also suggested that the theoretical price derived from Black Scholes formula would misprice the out of money (OTM) for both call and put option and that the volatility derived from theoretical price from Black Scholes model is not consistent with the operation of the market. Another explanation for the volatility smile of the equity option concerns leverage. Hull (2001) maintains that the implied volatility of equity options tends to be a decreasing function of the underlying share price and sometimes referred to volatility skew. His explanation for the varying volatility is that a company that has a decline in equity, which means the underlying stock price will decrease, would have a rise in the its level of leverage. The firm, as a result, will be perceived to be riskier and its stock volatility will increase. In this case, the smile effect is referred to the negative skewness or higher downside volatility. The OTM put options therefore should be priced at a higher value then. On the other side, when the equity increases, the firms leverage falls and its volatility stock would fall accordingly. In this case, the smile effect is referred to lower upside volatility and the OTM call options therefore would have lower value. The leverage argument is also studied and used to explain for the volatility by many researchers. For example, Dennis P. and Mayhew S. (2000) find that the steepness of the implied volatility smile depends on the beta of the stocks, a parameter which represents the market risk of the firm and has a correlation with the firms level of leverage. In fact, they find that the stocks whose is greater tend to

have a steeper smile. This positive relation between and the slope of volatility smile can because the demand for options to hedge the high market risk. Their study employs other firm-specific factors such as Price to earnings ratios, Book to market ratio to explain for the volatility smile. Even though Beta is a firm specific factor, it will not be used in this paper to explain the volatility smile because of two reasons: one is that the is not one of widely used proxy for investor belief, i.e. there have not been many studies about the relationship of beta and investor belief. The other reason is that of a particular firm is often estimated for a period of time, e.g. a quarter or half year, based on historical data and thus is not reliable and also is fixed, making it difficult to see the co-movement between two variables unless the data is used for many years. Toft and Prucyk (1997) explained the implied Black Scholes volatility by constructing the model with the put and call options written on leveraged equity. Their result suggests that highly levered firm would see their options having steeper smile than a firm with lower leverage. Moreover, they find that the difference in the smile shape also lies in the way the firm is financed, that is the smile is steeper for firm with high ratios of short term debt relative to total debt than for firm with only long term debt. Derman (1999) studied the leverage effect and volatility feedback and suggests that the co-movement between the volatility index and equity index is negative, i.e. an equity decrease tends to correspond with a rise in volatility. Pena (1999), furthermore, gives one explanation for the smile effect of stock options. He suggests that it is the transaction costs and liquidity that influence the curvature of option implied volatility smile. Pena (1999) used the bid ask spread to proxy for the transaction costs, which is also used to inform the liquidity of options, and by using the simple regression framework he discovered that the higher transaction costs tend to be associated with the higher market values of ITM call option (OTM put options) and ITM put options (OTM call options). In other words, from Penas empirical evidence, the extreme options, measured in terms of moneyness, have the highest bidask spreads. He also finds that the higher transaction costs reflect the selection costs when the market makers negotiate about the price of the options. Pena (1999) further pointed out that the degree of uncertainty and market momentum are two key determinants in explanation for the smile effect of options. The degree of uncertainty refers to the arrival of new information that causes the trading volume and

volatility increase. Market momentum means the market condition improves relative to the past and this is also believed to cause the volatility increase. Even though these researchers would have used other more complicated framework, the fundamental approach used in the study of Pena and of other many researchers trying to explain variability of implied volatility function is to find the variables to represent for a particular factor and then run the regression. The methodology which is discussed in later part of this project also relies on the approach of these studies. One more popular explanation for the skewness of the volatility suggested by Rubinstein and was also observed from the market is that the investors are concern about the market crash and Rubinstein use the term crashphobia to explain for this concern. Prior to 1987, there was no marked volatility smile, but since the market crash in 1987 the volatility smile used by traders has had the general form referred to as volatility skew. For that form, the implied probability distribution has heavier left tail and less heavy right tail than the log normal distribution. There have been several empirical supports for this explanation. Declines in the value of S & P 500 tend to be accompanied by a steepening of the skew. When the S&P 500 increases, the skew tends to become less steep. Other explanations for the smile effect are suggested by Hull and While (1988), Stein and Stein (1991) and Heston (1993). They believe that the varying volatility of underlying stocks can be explained by the stochastic volatility models for options. Stochastic volatility is opposite to the constant volatility assumed by Black Scholes model. It is the volatility that is based on the varying random price of underlying security. Another explanation is that the smile effect can be attributed to the size of the portfolio of mutual funds. The size of many funds portfolios are often very large and it is a safe position for the managers to buy puts to protect their fund against downside movements in a sense similar to paying the insurance premium. As a result, the puts price are drive up to a higher price relative to the price of the call options, and thus the downside implied volatility are also drive up relative to the upside implied volatility, making the volatility smile more pronounced. And last but not at least, Shefrin (2001), Ziegler (2003), Buraschi and Jiltsov (2005) believe the volatility smile is caused by the divergence of investor belief. The findings

of these studies will be discussed in more detail later since they are related to the objective of this paper. 4/ BACKGROUND OF DIVERGENCE OF INVESTOR BELIEF: The divergence of investor belief or common term - heterogeneity is a normal event not only in the stock market but also in any other markets since if we did not have heterogeneity, there would be no trade (Arrow Ken, 2004). However, the heterogeneity of expectations is one issue that is normally assumed to be non-existent in many important models in modern finance theory. In fact, even most important models such as SLM (Sharp, Lintner and Mossin) and Capital Asset Pricing Model (CAPM), is established under the paradigm of homogeneous beliefs, which assumes that the individuals are alike. To be more specific, the assumption of identical investors expectation refers to a situation in which individual investors are presented with plans having different level of returns at a given level of risk, and the investors will opt for the plan with the highest return. Similarly, now if the investors are presented with plans having different level of risk at a given level of return, then the investor is assumed to choose the plan with the lowest risk. This homogeneous belief assumption proves unrealistic because a certain investor can be more optimistic and confident in their estimates of returns, which can be the results of trading experience or gene that are in contrast to an investor who are faint-hearted and are pessimistic. Moreover, even when investors may have the common information about the stocks, they still may interpret that information in a different way. Also, this assumption cannot explain the increased trading volume around some events, for example the dividend payment or earnings announcements, The divergence of investor belief refers to the investor optimism or pessimism towards the future productivity growth. And it is the divergence of investor opinion that plays pivotal part of market movements. For example, when enough bearish investors change their opinion about the underlying fundamentals, a bull market can turn around to the bearish one. Moreover, divergence of opinion also implies the uncertainty or risk existing in the market. Miller (1977) confirms that the divergence of opinion is likely to increase with the risk. This relation between divergence of opinion and uncertainty can be seen through the empirical relations between the

divergence of opinions and future asset returns. Miller (1977) proposed the overvaluation theory in which he suggests the divergence of opinion lead to the overvaluation. Using this overvaluation theory, he implies that the optimism of investors will lead to low future returns. On the other side, William (1997) in the risk theory suggests that the heterogeneous investor belief reflect the uncertainty in the market and thus require a higher level of return, which he implies that the pessimism will lead to higher future returns. However, the nature of the relationship between heterogeneity and stock return is still not firmly defined. In fact, while later studies of Diether (2002) and Goetzman (2005) suggest a negative relations between future stock return and investor heterogeneity, i.e. greater divergence of opinion, lower returns, the results of Anderson (2005) and Doukas (2006) reveal a positive relation between two of them, i.e. greater heterogeneous belief, higher returns. Despite the unclear answers to this relationship, their results seem to justify the practical operation of the stock market. In fact, it can be observed in the market that the optimistic investors tend to bid up the stock price and when the heterogeneity increases, i.e. more investor become optimistic, it will lower the future return of the stocks. On the other hand, pessimists tend to drive the price down and with the increased divergence of opinion, i.e. the market has more pessimistic investors, the future stock return would be higher. The effect of heterogeneity on the assets price as well as its high correlation with risk prompted many researchers to consider heterogeneity as a factor in the pricing models, e.g. CAPM. These theoretical and empirical studies supporting the fact that there is the influence of divergence of opinion or heterogeneity among investors on the stock price, however negative or positive the effect is, provide a very important base supporting the existence of relationship between heterogeneity and option implied volatility smile, which is also the primary purpose of this research. Indeed, if the purpose is to prove that the shape of the volatility smile is truly directly affected by the dispersion in investor opinion, it is very important to have a concrete evidence showing that the heterogeneity do have an effect on the future movement of the underlying stock price on which the option is written since the volatility smile is primarily due to the high expectation of future movement of underlying stock price in deep OTM call and deep OTM put options.

Moreover, the confirmation of close relations between divergence of opinion and risk by Miller (1977) lends the support to the existence of relationship between heterogeneous belief and option implied volatility smile since it is reminded that the risk is statistically represented by the level of underlying stock volatility. Knight (1921) also confirms that as the uncertainty, i.e. risk, about the future payoffs increases, so does the divergence of investors belief increases. In conclusion, the relationship among divergence of opinion, volatility smile and stock return (asset prices) is an interdependent relationship since the volatility smile is the direct result of divergent investors belief towards the future movement of the underlying stock. As will be seen in later parts, most of the proxies for heterogeneous belief from previous studies, which are also employed in this paper, are derived on the basis of the relations of heterogeneity with the stock returns. The next two sections will be devoted to review previous papers: The first is about studies that empirically and theoretically support the existence of relations between volatility smile and divergent beliefs. The second is about studies that show the findings of factors affecting the smile shape, which is relevant to the objective of empirical research of this project. PART B 5/ THE FINDINGS OF RELATIONS BETWEEN IMPLIED VOLATILITY SMILE AND DIVERGENCE OF OPINION Various studies show that the divergence of opinion does have an impact on the value of call and put options and therefore it can explain the phenomenon of smile. Shefrin (1999) relates the volatility smile to heterogeneous belief through explaining how the disagreement causes the market to be inefficient. According to him, the volatility smile of index options is one indication of an inefficient market stemming from divergence of investor beliefs. He disagrees with Fama about the explanation of market efficiency. Fama (1998) suggests that investor overreaction will be cancelled out by investor underreaction, thus making the market to be efficient. Shefrin (1999), on the other hand, believes that the investor disagreement can cause the market to be

inefficient. Using the event study about irrational exuberance to describe investor sentiment, he argues that even if the strength of bullish opinion is matched by that of bearish opinion, the market prices of call options can still be bid up by bulls and market prices of put option can still be bid up by bears. By examining the information of option data with the information about market sentiment, Shefrin (1999) discover that the volatility implied from index options written on Standard and Poor 500 index exhibited a smile and he relates this smile effect to the differences of beliefs among investors. He discovered that the market prices of OTM call options were bid up by optimistic investors, which would simultaneously steepen the call slopes, and the pessimistic traders would drive up the OTM put options price and simultaneously steepen the put slope. Also, his results show that the volatility smile would become more pronounced as this belief differences becomes greater. The findings of Shefrin (1999) corresponds with that found by Rubinstein and Cox (1985). The latter use what is called use of certain kinds of special knowledge to explain the phenomenon of volatility smile, that is investors with bullish expectations gained from special knowledge are attracted to buy OTM calls from bearish ones and, in contrast, the bearish investors are attracted to buy OTM puts from the bullish ones. Shefrin identifies the OTM options in terms of moneyness, which he defines as the ratio of exercise price (K) and underlying stock price (S). The moneyness of Shefrin will also be used in the methodology of this paper to identify the OTM call and put options. Shefrin (2001) in his studies about the effect of sentiment, which is an alternative term for investor belief, on the valuation of assets classes such as stocks, bonds, and options, he divided the pricing kernel into two elements, one relating to the underlying fundamentals and the other relating to sentiment element. He discovered that when the sentiment part is non-zero, i.e. traders are different from each other in terms of belief, risk aversion it can have an impact on option prices and lead to the smile effect. He also suggests that the smile effect for call options is not similar to the smile effect for put options.

Buraschi and Jiltsov (2006) find that a model taking heterogeneous belief into account can explain the smile effect better than a stochastic volatility model. Their approach is to present the agents with an uncertainty model in which the dividend growth rate are allowed to be stochastic, i.e. future dividend is based on random variable. In order to construct an optimal portfolio, these agents have to make estimates on the future dividends. These agents are assumed to incorporate all available information into their estimates in order to obtain optimal portfolio. Buraschi and Jiltsov use the point at which trading occurs to determine the divergence in belief of these agents, which is consistent with the argument presented earlier that the trading would occur when the heterogeneity occurs. The results of Buraschi and Jiltsov is similar to that of Shefrin (1999), that is the agents with a pessimistic posterior towards the dividend growth rate would require a protection from the optimistic counterparts, which can be achieved from buying deep OTM put options, which has the effect of bidding up the put option price. Likewise, agents with optimistic posterior towards dividend growth rate would demand the deep OTM options from the pessimistic counterparts, which has the effect of driving up the call price. They refer these actions of those agents, both optimistic and pessimistic, to what they called risk sharing, which means the optimists write the put option and the pessimists will write the call option. Moreover, they point out that the reason the heterogeneous belief can explain the varying function of volatility is because the marginal utility of both types of agents is different from each other. Benninga and Mayshare (2005) studied how the investors with heterogeneous degree of relative risk aversion affect the equilibrium option pricing. They find that the put options prices are positively correlated with the level of agents risk aversion, i.e. the put options tend to be associated with the high risk aversion. They use the term crashophobia suggested by Rubinstein (1994) to interpret their results. In fact, the term crashophobia refer to the fact that those who seek to hold OTM put options as an insurance protection against the crashes, similar to Black Monday 1987, would be considered to be relatively highly risk averse. And finally the most recent study of Li Tao (2008) suggests that a model which incorporates the heterogeneous belief can explain main features of the implied volatility. In their option pricing model, the investors are assumed to be heterogeneous

in their beliefs and preferences. To be more specific, the investors have their divergent beliefs about the economic fundaments, i.e. dividend and cash flow stream (endowment stream), and have different time preferences, i.e. discount rate. Their findings reveal that the pattern of volatility smile is associated with belief differences, time preferences and the level of wealth. If the majority of total wealth is held by pessimistic investor, the pattern of implied volatility exhibited a skewness, while if a large portion of total wealth is held by optimistic investors, the pattern of the implied volatility show a smile. In conclusion, the findings of previous studies have provided both theoretical and empirical evidence for the relations between volatility smile and divergence of investor beliefs. 6/ THE FIDINGS OF DETEMINANTS OF IMPLIED VOLATILTIY SMILE This section will present the findings about the effect that factors, which are used by other researches in previous paper, have on the slope of the option implied volatility smile. These factors include both ones widely used as proxies for belief differences and ones that are not. Perhaps the two most relevant studies to the objective of this paper is the research of Dennis and Mayhew (2002) and Chang and Lin (2010). Chang and Lin (2010) investigate the influence of firm-specific factors and market-wide factors on the slope of implied volatility smile of individual stock options on the LIFFE (London International Financial Futures and Options Exchange). To be more specific, for firms-specific factors, their result indicates that firms with higher level of leverage, larger firm size, higher beta and greater trading volume would see their option implied volatility smile become more negative smile slope, i.e. the more negative put slope on the left end of the smile. This finding is similar to that of Dennis and Mayhew (2002). However, for the firm size factor, which is used as one of proxies for heterogeneous beliefs, the finding is in conflict with that of Diether (2002) and Baik and Park (2003) who maintain that the relation between firm size and slope of implied volatility smile is negative. This conflicting result will be discussed in details in the later section of heterogeneous belief proxies and smile shape. Another finding from the study of

Chang and Lin (2010) in the firm-specific factor category is that firm whose stock is more volatile would have a volatility smile of less negative slope. Regards to the effect of market-wide variables on volatility smile, Chang and Lin (2010) discover that the market with greater volatility would make the smile more pronounced. This comes as no surprise since greater market volatility implies a greater level of uncertainty. Moreover, they found that when the skewness of the FTSE100 index becomes greater, slope for the individual stock options will become greater. Dennis and Mayhew (2002) also pointed out that the put to call trading volume ratio or put to call open interest ratio is one of the determinants of the volatility smirks, with more put volume revealing more pessimism. They predicted that the smile curve would be downward sloping or equivalently have more skewness in the curve when there are times of high trading of put. Since the number of put and call open interest is commonly believed to be a sentiment index, this would be elaborate in the next section. In an attempted to identify the determinants of implied volatility curve in equity options, Angelo (2010) tried to examine to see if certain fundamental variables are related to the changes in implied volatility, which is equivalent to testing the effect of fundamental variables on the smile. Besides employing firm size as one variable similar to approach of Chang and Lin (2010), Angelo (2010) used two additional variables, namely value effect (measured in book to market ratio) and industrial effect (measured in 2 digit SIC code). His approach is to run the OLS regression of fundamental variables against the implied volatility. The result reveals that the value for firm size and book to market ratio are statistically significant, yet the value for industry effect is not statistically significant. In summary, from the findings of Dennis and Mayhew (2002), Chang and Lin (2010) and Angelo (2010) it is concluded that the slope of volatility smile can be influenced by firm-specific factors, which are represented by level of leverage, firm size, beta (market risk) trading volume, book to market ratio of underlying stock and level of stock volatility; and market wide variables, which are represented by the level of volatility of the whole market and the skewness of the index. Put to call ratio is also one popular determinants of the smile slope. Finally, Dennis and Mayhew (2002)

added that firm specific factors prove to be more significant than systematic factors in explaining the variation in the skew for individual firms. 7/ THE HYPOTHESES OF THE RELATIONSHIP BETWEEN HETEROGENEITY PROXIES AND IMPLIED VOLATILITY SMILE IN EQUITY OPTIONS This part presents the six variables that are commonly taken as proxies for divergence of investor beliefs followed by the hypotheses which are set based on the results in the findings of previous paper. The first proxy for heterogeneous belief is dispersion in financial analysts earnings forecast. This factor appears to be an appropriate proxy for belief differences among investors since the dispersion in forecast of earnings made by financial analysts obviously reflects their belief differences, their expectations about the future. Optimistic analysts would make higher consensus earnings estimates than the actual ones, while pessimistic analysts make lower consensus earnings estimates. As a results, the investors belief, especially which of institutional investors, who rely heavily on the consensus earnings forecasts to make investment decisions, would also be affected. The greater the dispersion in earnings forecasts of analysts, the greater the belief differences among investors. The earnings in the forecast of analysts mentioned here is Earnings Per Share. This metric is estimated as the company's net earnings - or net income found on its income statement - less dividends on preferred stock, divided by the number of outstanding shares (Investopedia, 2010). Luckily, it is not necessary to estimate this metric in the paper since what is required is only the dispersion the deviations from the average in earnings per share estimated by financial analysts and this issue will be elaborated in the section of data sample. In fact, the use of the dispersion in analysts earnings forecasts as proxy for divergence of belief were used by Diether, Maylloy and Scherbina (2002), Doukas (2004) and Cen, Wei, and Zhang (2007). The study of Goetzman and Masa (2003) indicates that the dispersion in analysts earnings forecasts is positively correlated with the heterogeneous beliefs. Moreover, it has been presented in the section of relations between heterogeneous belief and volatility smile that the smile shape would

become more pronounced, i.e. more negative put slope or more positive call slope, when the beliefs among investors are more divergent. For that reason, the first hypothesis is: Hypothesis 1: The underlying stock with greater dispersion in financial analysts earnings forecasts would have more pronounced volatility smile, which is equivalent to the fact that the dispersion in financial analysts earnings forecasts is negatively associated with put slope and positively associated with the call slope. The second factor is another widely used proxy for belief differences firm size. One reason many believe that firm size is an sensible proxy for belief differences is because large firms receive much more attention from the market participants than the small firm do and therefore their beliefs may be different. To be more specific, the investors tend to have quicker and more sufficient access to the information of large firms, whereas small firms often do not have such radically available information, making the evaluation of them more various. Yet, since the papers uses sample of listed firms, this explanation seems not to be convincing. From the empirical results of Dennis and Mayhew (2002), Chang and Lin (2010) in the previous section, the firm size has a positive relationship with the slope of the implied volatility smile, which means that the divergence of opinion is greater for larger firms. However, Baik and Park (2003) suggest an opposing idea saying that divergence of opinion is greater for smaller firms. This paper follows the idea suggested by Chang and Lin (2010) since their results are obtained from testing options on LIFFE which is also the options used in this paper. The second hypothesis is therefore: Hypothesis 2: The underlying stocks of a larger firm would have more pronounced volatility smile than a smaller firm, which is equivalent to the fact that the firm size is negatively associated with put slope and positively associated with call slope. The third proxy for divergence of investor beliefs is related to the classification of growth stocks and income stocks. According to definition of Investopedia, growth stocks or glamor stocks are stocks that pay few or does not pay dividend as the firm

tends to retain the earnings for capital projects. Income stocks are stocks that pay regular dividends and thus offer relatively high dividend yield. There are two conflicting ideas regarding the relationship between divergent beliefs and the classification of growth stocks and income stock. While Baik and Park (2003) discovered that stocks with higher price to earnings ratio, which is growth stock, induce greater belief differences than stocks with lower price to earnings ratios, which is income stock. Doukas (2004), on the other hand, maintains that the belief differences are higher for stocks with lower price to earnings ratio when he found out that the divergence in analysts earnings forecasts is much higher for portfolio consisted of value stocks (low price to earnings ratio stocks). Value stock is generally similar to income stocks in some respects since they offer high dividend yield, low price to book ratio, low price to earnings ratio The explanation for greater belief differences for growth stocks than for income stocks could be because of investor attitudes towards the dividend growth rate. In fact, since the income stocks offer more stable dividend than growth stock, and more importantly, as it is pointed out earlier that investor beliefs are affected by the dividend growth rate (Buraschi and Jiltsov (2006) and Li Tao (2008)). For these reasons, the hypothesis of greater belief of investors for growth stock seems to be more convincing. Hypothesis 3: Growth stocks would have more pronounced volatility smile than income stocks, which is equivalent to the fact that the price to earnings ratio (P/E ratio), i.e. one metric to identify growth stocks and income stocks, is negatively associated with the put slope and positively associated with call slope. The fourth proxy for belief differences is price to book ratio (or market to book ratio). The findings of Baik and Park (2003) Doukas (2004) suggest a positive relationship between book to market ratio and dispersion in analysts earnings forecast. In their regression models, the book to market ratio is explanatory (or independent) variable, and dispersion in analysts earnings forecast is dependent variable, the regression results show a positive correlation in their relationships. Therefore, strictly it is sensible to say the beliefs among investor become more divergent when the book to

market ratio is higher. Since the report uses the data of price to book ratio, the fourth hypothesis is therefore: Hypothesis 4: The underlying stocks with lower price to book ratio (P/B) would have more pronounced volatility smile, which is equivalent to the fact that the price to book ratio is positively associated with the put slope and negatively associated with the call slope. The fifth proxy is open interest of put and call options. Open interest is the number of outstanding contracts of put and call options in a particular day. Buraschi and Jiltsov (2003) use the Survey of Professional Forecasters and the Consumer Confidence Survey to construct what is called Difference in Belief Index and they found a link between heterogeneous belief and open interest of index options. Dennis and Mayhew (2002) and others indicate that high heterogeneity lead to more open interest contracts. Increase in open interest of call options suggests a higher optimism among investors as they tend to use call option to as tool of leverage. In contrast, an increase in open interest of put options indicates more pessimism among investors who use the put option to provide protection against downside risk. Put to call ratio of open interest is more commonly used than open interests only since looking at put to call ratio one can have an idea of how much pessimism the investors have towards an individual option. A ratio of more than 1 implied a more pessimism relative to optimism. The fifth hypothesis is therefore Hypothesis 5: Underlying with more open interest on OTM options would have more pronounced volatility smile, which is equivalent to the fact that the open interest of put option is negatively associated with the put slope and the open interest of call option is positively associate with the call slope. The sixth proxy is trading volume of underlying stock. The volume of trading on stocks are used as proxy for differences of opinion by Raviv and Harris (1993), Dennis and Mayhew (2002), Bauer (2003) and Chang and Lin (2005) and others. Chang and Lin (2005) even use the trading volume to directly test the hypothesis that the slope of implied volatility is steeper for high traded stocks.

Bauer (2003) examines the impact of divergent beliefs on trading stock volume and found that disagreement on the mean growth rate lead to an increase in expected trading volume. And the effect of different beliefs is more significant when the investors have more divergent beliefs, which suggest a positive relationship between heterogeneity in beliefs and trading volume. Therefore, the trading stock volume proxy is expected to be positively correlated with the slope of implied volatility smile. Hypothesis 6: The stocks with higher trading volume would have more pronounced volatility smile, which is equivalent to the fact that the trading stock volume is negatively associated with the put slope and positively associated with the call slope. Besides testing the relations between heterogeneity proxy and volatility smile shape, the report also aims to test the hypothesis concerning the relationships between market-wide variables and steepness of implied volatility curve. As presented in earlier section, the empirical findings of Chang and Lin (2005) reveal that the more skewness of the FTSE 100 index options would make the volatility smile slope of individual options steeper. The final hypothesis the paper wants to test is therefore Hypothesis 7: The skewness of FTSE 100 index options is positively associated with the steeper slope of individual stock options.



1. DATA In the empirical research part, the paper uses the data on Options written on stocks traded on the LSE. Initially, a list of firms that have option is taken from LIFFE (stands for London International Financial Futures and Options Exchange). Yet, due to the availability of data, a sample of 38 plc companies that have options is selected to put on test for those hypotheses presented above. The primary options data are obtained from Bloomberg database. The option data involves information on bid ask quotes, volume, open interest, and yet for the implied volatility Bloomberg does not provide an historical data implied volatility and

therefore it requires an estimation of volatility implied from the market prices provided using Black Scholes formula. To be more specific, implied volatility is computed using the average price of bid ask spread. Any put or call options that violate the upper bound and lower bound, known as arbitrage bounds, would be deleted. In general, throughout the process of retrieving option data, one criteria to include an underlying stock in the firm is that it must have open interest and sufficient data. Moreover, ITM options are ignored since they are often less liquid than ATM or OTM options. As optimistic investors demand OTM call options whereas pessimistic are attracted by put options, the effect of heterogeneity belief on volatility smile can be adequately observed using only OTM options. The most important data on options is implied volatility which will be computed from the market price of call and put options. Since most actively traded options are ones with the nearest time to maturity, this research only employ options with options with contractual term less than 6 months. Indeed, the expiration month for options of firms in the sample is in August, September, and December 2012 and the point of time of retrieving data is in August, which means that options put to the test have time to maturity of up to 3 months. Despite the short time to maturity of the options, the availability of historical data of these options are considered very carefully before being selected. The historical data, particularly the market price, of the options is of paramount importance because it is needed to examine the correlation between proxies representing for investors beliefs and implied volatility directly traced from call or put market price. Besides historical data for options, the firm - specific data of 30 firms in the sample have also been obtained. To be more specific, the firm - specific data includes data about firm size (which is represented by market capitalization), price to earnings per share (P/E ratio), price to book ratio (P/B ratio), stock trading volume. Firm specific data is vital in testing hypotheses since, as can be seen, five out of seven hypotheses involves the firmspecific data.

The importance of those types of data will be discussed later in methodology part detailing the way in which options and firm-specific data will be combined to test seven hypotheses presented earlier. The detailed definitions of each type of data by Bloomberg are also provided in Appendix. Just to give one definition from Bloomberg about the divergence of investors belief as an example, perhaps one of the most inconvenienced sort of data used to proxy for differences in investor belief is dispersion in financial analysts earnings forecasts. Fortunately, Bloomberg provides the metric called earnings per share (EPS) standard deviation which is defined by it as a statistical measure of the dispersion of the contributed Earnings per share (EPS) estimates around their mean value expressed in the same units as the data. The standard deviation of a consensus expresses the level of agreement amongst the contributed data. A consensus with a high standard deviation would represent more dissent while a lower standard deviation would represent concurrence. And from this definition of EPS standard deviation, it is seen that it matches the definition suggested by Bak and Paik (2003) on the dispersion of analysts expectations which says that dispersion is defined as the coefficients of variation in analysts earnings forecasts, which is the ratio of the standard deviation to the mean of earnings forecasts. (Bak and Paik). For all these justifications, the EPS standard deviation from Bloomberg can be used as data for the first proxy of investor belief differences - dispersion in financial analysts earnings forecasts. 2. METHODOLOGY This part describes how the hypotheses will be tested and the data, especially options data, will be processed to provide the information which then will be used to test hypotheses. Also, it shows the way the results will be interpreted. First of all, with regards to the methods of testing hypotheses, the paper will briefly review at the theory of correlation and regression which are adopted as the main approach to examine the relationship between divergence of beliefs and the shape of volatility smile. It is considered an primary approach because the idea behind regression and correlation is relevant to the objective of this paper, which wants to

understand the effect of one or several variables, which in regression theory is called independent variables, might have on one dependent variable.. Looking at over all seven hypotheses, it is easy to identify independent variables and dependent variables from the view of regression theory. In fact, independent variables in this case are proxies for investor beliefs differences, namely dispersion in earnings forecasts by financial analysts, firm size, P/E ratios, P/B ratios, open interest, and underlying stock volume trading. On the other hand, the dependent variable is the shape of volatility smile. And because the purpose is to try to understand how the slope of option implied volatility smile would change when these factors change, the understanding of correlation and regression model is necessary. In regression theory, there is one metric called correlation coefficient which is used to measure the degree of association between two variables. Overall, if the correlation coefficient is found statistically significant, there is a relationship between the independent variable and dependent variable and that is exactly what these hypotheses will be put on test. A regression model is an equation for predicting values of one variable from values of one or more variables. The arithmetical rule for a regression model will have a simple form as follows: Y = SlopeX + Constant It can be extended to include more independent variables as follows: Y = SlopeX + SlopeZ ++SlopeH + Constant Alternative terms for X, Z or H are predictor (independent) and Y as predicted variables. The regression model above, in practice, is used to assess the impact of one variable one another. So, from the equation describing the relationship above, the relationship between the divergence of beliefs and implied volatility smile can be demonstrated through the regression model of the Put (Call) slope (dependent variable), which represents for

smile shape, and six commonly used proxies (independent variable), which represents for investor beliefs. Put (Call) slope = + 1Dispersion + 2Size + 3P/E + 4P/B + 5OpenInterest + 6StockVolume + 7IndexSkewness (*) The equation above looks quite different from the original one but they are the same in essence, with representing for the intercept or constant value and for the slope. Now, from the objective of this paper, the effect of divergence of beliefs on implied volatility smile has been constructed through the equation (*). After having described the relationship of smile shape with other proxies for investor beliefs under a arithmetical equation, the next stage is to carry out the null hypothesis test. It is noted that the null hypothesis test is not the tests of seven hypotheses put forward earlier, even though they are closely related. Strictly, the hypothesis tests are always null, which means there is no relationship between two variables. It is always null, nothingy hypothesis. If the null hypothesis is true, any relationship or difference in the data must just be due to chance. The null hypothesis test typically consists of three steps: Step 1 is to formulate the null hypothesis. From the definition of null hypothesis, the null hypothesis regarding the objective of this paper is that there is no relationship between implied volatility smile and the investor beliefs, which equivalently means there is no relationship between put (call) slope and proxies for investor beliefs. Step 2 is to estimate the p value. p in this case stands for probability if the null hypothesis is true. In other words, it suggests how likely the results are to have occurred if the null hypothesis is true. Step 3 is to draw conclusions. From the meaning of p value, it means the lower the p value the less plausible the null hypothesis is and the more plausible it is that the alternative hypothesis is true, which suggests there is systematic relationship between variables and that relationship is statistically significant at a certain confidence level. The cut-off level of significant in this paper is taken as 5 per cent. Therefore, if the p

turns out to be more than 5 per cent, then the results would be seen as not significant, meaning the weak evidence that the null hypothesis is not true. In other words, the lower the p value the stronger the evidence that the null hypothesis is not true. Therefore, the null hypothesis tests are sometimes referred to as significant tests. The second part in the methodology section is the description of processing data to make them suits to the purpose of this paper. In fact, the data of options and listed firms in the sample is raw data; therefore the recompilation of these data is required for further empirical analysis. One of the most important information that needed to be extracted from the option data is the put slope and call slope. It is because they directly represent for the curvature of the implied volatility smile. Moreover, since the objective of the paper is to see if the greater divergence of investor beliefs truly makes the smile slope steeper, the derivation of put slope and call slope plays an important role in testing the seven hypotheses of relations between smile and shape and investor belief proxies. Using what is called moneyness, the term used by previous researchers in computing put and call slope, the paper use moneyness to calculate the put and call slope. Moneyness of an option is defined as the ratio of the exercise price (K) and the underlying stock market price (S). Under moneyness, options can be categorized different from the conventional way, specifically: At the money (ATM) options will have 0.95 <= K/S <= 1.05 instead of K = S Out of money (OTM) call options will have K/S > 1.05 instead of K > S Out of money (OTM) put options will have K/S < 0.95. From the new definition of ATM and OTM options under the moneyness, the smile slope for OTM options will be computed by using the following equation:



i is the call or put In the equation above, IVOTMi is the implied volatility of OTM options and IVATMi is the implied volatility of ATM options, the difference between those two implied volatility will then be divided by the difference between the moneyness. From the equation (**), the put slope then will be negative and call slope will be positive if the volatility curve show the smile shape not the skew one. The determination of put and call slope, as said earlier, is very important since put (call) slope will be used to run the regression against the proxies for divergence of investor opinion. From the equation (**), in order to calculate the put (call) slope, only the OTM and ATM options are needed, other type of options, i.e. ITM options are unnecessary and thus will be deleted. Based on the classification of OTM and ATM options by the Moneyness, which is retrieved by dividing the exercise price (K) by the prevailing underlying stock price (S) Table 1 is the summary of the number of OTM and ATM options under the classification by their Moneyness. Table 1: Summary of number of OTM and ATM options from sample of 38 firms Classifications of Options under Moneyness OTM call options OTM put options ATM options Number of options 162 146 117

It is emphasized that the Moneyness of Options, i.e. K/S, will be the criteria to classify these options and other options that do not belong to these criteria will not be considered.

From those OTM and ATM options, the implied volatility of put and call slope will be computed. Generally, there are several ways of computing the OTM and ATM options implied volatility. One way is to use Derivagem software package which is easy to use and more importantly does not involve complicated calculation. However, using Derivagem to compute implied volatility is only efficient for just a small number of options, when there is a large number of implied volatility needed to be calculated, e.g 100 market prices or 100 implied volatility, this method proves to be daunting and very time consuming as it always requires the re-input of information about stock price, strike price, time to expiration in order to find the corresponding implied volatility. Therefore, it is very important to find out a faster and more efficient way to calculate implied volatility. An alternative way is to use the Black Scholes formula combined with the Solver function in Spread sheet to trace the implied volatility from the market price of options. To be more specific, for every single option with one particular strike price, the theoretical price of that option can be estimated using Black Scholes formula. Subsequently, using the Solver function in Excel, the implied volatility can be retrieved from the market price of the options. With the powerful function of Spread sheet, the calculation of implied volatility for as much as 10,000 or even more, is not of a significant problem. The derivation of implied volatility using Black-Scholes model and market price of options is detailed as follows: Step 1: The theoretical price of the option with a particular strike price and term to maturity are estimated using the Black Scholes formula Value of call option = N(d1).S N(d2).K2 Value of put option = Ke-rT.N(d2) S.N(-d1)
( )

Where d1 = d2 = d1 -

The formula above seems to be complicated but thanks to the powerful function of spreadsheet, the theoretical call and put price of all the options can be worked out easily as long as the correct equation is in place. Step 2: By substituting the market price with the theoretical price obtained above, the implied volatility can be estimated by using Solver function, which requires other elements in the equation, i.e. K, S, T, r, to be kept unchanged. After obtaining the implied volatility of OTM and ATM options (classified under moneyness of options), the Slope of call and put options are obtained using equation (**). So far, the estimation of implied volatility and slope of call and put options has been presented. However, in order to run the regression between the slope and other proxies for investors beliefs to see the correlation between those two variables, it is important to obtain a single value for put (call) slope. Therefore, for each day in the window of historical data, the Moneyness and implied volatility of options are averaged based on the total number of OTM and ATM put (call) options which is presented in the table 1 above. Therefore, the put slope and call slope can be calculated. Next, after discussing the process of preparing the value of the variable on the left of the equation (*), i.e. put and call slope, the paper would carry on explaining the way in which the values of the other variables on the right of the equation (*) are prepared. Namely, these variables are: Earnings per share standard deviation: (representing for Dispersion in financial analysts earnings forecast). Market capitalisation: (representing for firm size) Price to book ratio Price to earnings per share Open interest Stock trading volume

Generally, compared to the process of estimating put (call) slope, the preparation of data for the variables above involves much less computational work since the data retrieved from Bloomberg has already suits the purpose of this paper. For the EPS standard deviation, it has been discussed earlier that this metric

reflects how much the analysts forecasts are different, and the standard deviation, in this particular case, expresses the level of agreement amongst the contributed data. For the market capitalization which is used to represent for the firm size of

each firm in the sample. The market capitalization is total dollar market value of all of a company's outstanding shares at period end date. Calculated as: Shares Outstanding * Last Closing Price. For ratio of the stock price to the book value per share, it is calculated as:

Price to Book Ratio = Last Price / Book Value Per Share For ratio of the price of a stock and the company's earnings per share, it is

calculated as Last Price divided by Trailing 12M EPS before or Basic EPS Before XO(IS064, if only annual earnings exist. For stock trading volume, it is the total number of shares traded on a security

on the current day. If the security has not traded, then it is the total number of shares from the last day the security traded. If an exchange sends official closing price without a volume, the return will be '0'. If no closing price data is sent by the exchange, the return will reflect the last data received from the exchange. The pricing source in use must be set up to show volume, otherwise the field will return a blank. Open interest: the number of outstanding agreements for the selected contract.

With the put (call) slope and other proxies for investors beliefs in place, now only the regression of the smile slope on various proxies, which has already been shown in equation (*), is required in order to see whether there is a relationship between volatility smile and divergence of investors beliefs.



Table 2 below shows the descriptive statistics result of the implied volatility of the OTM and ATM options along with the computed put and call slope. As mentioned in

the previous section, the regression of dependent variable against one or more independent variables requires the values of these variables to be placed in different lines against each other. For example, Y 5 4 3 2 1 X1 5 4 3 2 1 X2 4 3 2 1 5 X3 3 2 1 4 5 X4 1 5 2 4 3

Because of that, the implied volatility and moneyness of options in the same category, i.e. OTM or ATM options, should be averaged out in order to obtain one single line of value of put or call slope, which means the put and call slope are estimated on the basis of average value of implied volatility and moneyness using equation (**).

Table II: Full sample Observation Average (means) IV of ATM 30,040 0.21 Standard deviation 0.19 22,830 Smile sample (76%) Observation Average Standard (means) 0.24 deviation 0.16 6,709 Skew sample (24%) Observation Average (means) 0.29 Standard deviation 0.33

options IV of OTM put 30,040 options IV of OTM call 30,040 options 0.25 0.36 22,830 0.29 0.16 6,709 0.24 0.26 0.32 0.54 22,830 0.30 0.18 6,709 0.31 0.23


30,040 30,040

-1.63 0.64

0.32 0.43

22,830 22,830

-1.73 0.43

0.42 0.31

6,709 6,709

-1.48 0.55

0.23 0.34

Sample includes the number of put (call) OTM and ATM options for 38 stocks over the last two years from 2010 to 2012. Therefore, the number of observations is the number of implied volatilities estimated in the observed period, i.e. two years. As said earlier, the smile slope, which is observed through the put (call) slope, is measured as the ratio of difference between implied volatility of OTM options and implied volatility of ATM options divided by the difference of the moneyness of OTM and moneyness of ATM options. Another point to note from the table is that in the full sample as well as smile sample and skew sample the average put slope (-1.63) is steeper than the call slope (0.64). Buraschi and Jiltsov (2006) suggest that the bad (good) state of economy and the high (low) level of uncertainty can account for the greater (lower) of the put slope relative to the call slope. There is 76 per cent of the option sample showing the smile slope, and 24 per cent with the skew shape, or known as volatility skew. The sample with smile shape includes options with the IV of OTM put options greater than the IV of ATM options and the IV of OTM call options are greater than the IV of ATM options. On the other hand, the skew samples consists of options with the IV of OTM put options greater than IV of ATM options and IV of OTM call options lower than the IV of ATM options. Other than that, in the sample there are also a number of options that has not shown skew or smile shape and thus they will be removed. The next table indicates the summary statistics for variables taken as proxies for investor beliefs, which will be used in the subsequent regression.

Table III: Variable OTM Put Option Put slope Open interest (thousands) Option volume (thousands) OTM Call option Call slope Open interest (in thousands) Option volume (in thousands) Variables for investor belief proxies Size ( in thousands) Dispersion P/E P/B Stock trading volume (in millions) Variables for Options on FTSE 100 index Put Slope Call Slope Open interest Call (Put) options -1.24 0.58 85 (186) 0.26 0.23 12.3 22.03 0.11 21.03 4.21 0.91 2.32 0.21 4.47 2.57 0.046 0.64 0.92 0.34 0.43 4.21 0.08 -1.63 1.34 0.16 0.32 2.32 0.03 Average (mean) Standard deviation

From the figures in table II, the summary statistics for variables used in hypothesis testing are clearly presented. There is an average of 1,340 daily open interests of put option interest but only 920 daily open interests of call options. However, the daily trading volume of call options clearly outnumbered that of put option, which is consistent with the findings of Bollen and Whaley (2004) suggesting that trading in stock options involves call options than put options. Means and standard deviation for other variables taken as proxies for investor beliefs are also summarized in table above. Most stocks in the sample of 38 stocks are of medium and large sized corporation because stocks of small firms do not have options. The size represents for the market capitalization and its mean is 22,030. The dispersion represents for the standard deviation of earnings forecasts made by financial analysts. So, the standard deviation of dispersion is in fact the standard deviation of standard deviation of analysts earnings forecasts. The average dispersion is 0.11 and the average daily stock trading volume is 910,000 shares. The average price to earnings ratio and price to book ratio are 21.03 and 4.21 respectively. Table 3 also presents the summary statistics for option trading on FTSE 100 index, which is used in the hypothesis testing of relationship between implied volatility slope of stock options and that of index options, which has been mentioned in the last hypothesis. The next table presents the most important part of this project the results of the regression between the put (or call) slope - representing for the implied volatility smile shape and the variables proxies for the investors belief. Since there are two separate regressions, one is for the put slope against the variables, and the other is for the call slope against the same variables, therefore the table VI is divided into VIA and VIB which shows the results for Put Slope and Call Slope, respectively.

VI A: The results from the regression between Put Slope and various variables, i.e. dispersion, size, P/E, P/B, Open interest, Stock trading volume and Indexskewness.

Coefficients Intercept Dispersion Size P/E P/B OpenInterest StockVolume Indexskewness 4.12 - 0.056 21.32 - 2.12 0.0091 - 0.67 -0.03 0.9568

t Stat 4.321 2.144 2.459 3.09 1.965 4.34 5.767 0.234

P-value 0.00321 0.04321 0.0000184 6.55197E-12 1.31491 2.55197E-10 0.0000079 0.234682

Adjusted R2 (%) 33.134

VI B: The results from the regression between Call Slope and various variables, i.e. dispersion, size, P/E, P/B, Open interest, Stock trading volume and Indexskewness.

Coefficients Intercept Dispersion Size P/E P/B OpenInterest StockVolume Indexskewness - 0.9518 0.00593 - 1.32097 0.820 2.3778 0.0003 0.0490 0.9822

t Stat 0.00068 6.320 2.483 3.000 1.119 4.002 2.943 0.349

P-value 0.0673 5.755197E-12 0.009832 0.000028 0.34392 1.40572E-10 8.27403E-12 1.94826

Adjusted R2 (%) 36.730

INTERPRETATION OF THE RESULTS: Those two tables above are compiled from the regressions of put slope and call slope against the variables taken for proxies of investors belief. The first figure that needs to be examined is adjusted square R. In both the regressions put slope and call slope, this figure is slightly the same, which is more than 30 per cent. The meaning of adjusted square R is that the proxies for investor beliefs, i.e. Dispersion in analysts earning forecast, the Firm Size, the P/E, the P/B, the Open Interest, Stock Volume and Index Skewneness, explain or accounts for on average 30 per cent in the variation of the put slope or call slope. However, in statistics, relying solely on R square to make conclusion about the relationship between independent and dependent variables is not sufficient as R square can be made higher by adding more predictors, i.e. independent variables. And in these two regressions, the level of 30 per cent for adjusted square R is acceptable. In order to conclude if there is existence of the relationships between divergence of investor opinions and option implied volatility smile, it is vital to give evidence to reject the null hypothesis that there is no relationship between those two issues. It has been mentioned in earlier sections that the p value indicates the strength of the evidence against the null hypothesis. From the regression results in table VIA and VIB, p value of such variables as Dispersion, Size, P/E, Open interest and Stock Volume are lower than the cut-off level 5 per cent, which suggests that there is enough evidence to reject the null hypothesis that there is no relationship between smile slope and these proxies for variable. However, the p value of the widely used proxy for investor belief P/B is higher than the cut-off level 5 per cent in both regression tests, which means that, within the empirical results of this project, P/B variable, taken as an proxy for investor belief, has no impact on the curve of the implied volatility smile. However, this does not prove that there is no relationship between P/B and smile slope, just that there is not enough evidence to be certain. In addition to p value, table VIA and VIB also presents the figures of t Stat that has similar meaning to p as regards to evidence to test the null hypothesis. As can be seen from the results, variables having p value lower than 5 per cent see their t Stat value

higher than 2.00, which also suggests more convincing evidence against the null hypothesis. Besides the unexpected result from P/B, the regression shows that the changes in skewness of index option volatility smile, expressed under Indexskewness variable, are not correlated with that of the stock options. After interpreting some of the figures in table VIA and VIB, it is seen that the effect that investor belief have on implied volatility smile is rather significant, with more than 30 per cent of the changes in option implied volatility smile being explained by the changes in proxies for belief differences. The Coefficients columns in table VIA and VIB enable to establish a complete mathematical equation showing the relationship between the investor beliefs and the option implied volatility smile, from which seven hypotheses presented earlier will be re-examined to see if they are accepted or rejected given the sample of data employed throughout this project. Remember the general arithmetic equation about the relationship between put (call) slope and the proxy variables is as follows: Put (Call) slope = + 1Dispersion + 2Size + 3P/E + 4P/B + 5OpenInterest + 6StockVolume + 7IndexSkewness (*) Therefore, based on the coefficients value in table VIA and VIB, the equation (*) can be rewritten as follows: For the Put Slope Put slope = 4.12 0.056Dispersion + 21.32Size 2.12P/E 0.67OpenInterest 0.03StockVolume. (1) For the Call Slope Call slope = -0.9518 + 0.00593Dispersion - 1.32097Size + 0.82P/E + 0.0003OpenInterest + 0.049StockVolume. (2)

In the first hypothesis that states the increases in Dispersion in financial analysts earning forecasts would make both the put slope and call slope steeper, which equivalent to the fact that the higher the dispersion, the lower the put slope and the higher the call slope. Moreover, since under the equation (**) the put slope is negative and call slope is positive, the put slope should be negatively correlated with Dispersion and the opposite is true for call slope. From equation (1) and (2) above, the first hypothesis is accepted. With regards to the second proxy that suggests that the larger firms have more effect on the smile slope than the smaller firms and that the firm size is negatively associated with the put slope and positively associated with the call slope. In other words, the sign in the equation would be minus (-) for the coefficients value of Size in the Put slope equation and plus (+) in that of the Call slope. However, the obtained results show the opposite. That is, the larger the size of the firm, the lesser the effect it has on the volatility smile. In other words, the smile slope tends to be steeper for the small firms as it can be explained that the traders are more different from each other towards the performance of the firms with smaller size. This arguments is consistent with that of Baik and Park (2003) who believe that the divergence of investor beliefs is greater than for smaller firms. The fourth proxy is about the relationship between another widely used proxy for investor beliefs - the P/E ratio and the put (call) slope. The explanation for the correlation between those two variables has been mentioned in the section of establishing hypothesis earlier. The fourth hypothesis

As to the third and seventh hypothesis, since the empirical results in this project do not support the existence of the relationship between these proxies for investor belief, i.e. Price to Book ratio and Skewness of the Index, and the volatility smile shape, therefore these two hypotheses are rejected.