Pricing event risk: evidence from concave implied volatility curves

Abstract We document that implied volatility (IV) curves of short-term equity options frequently become concave prior to earnings announcements day (EAD), typically reflecting a bimodal risk-neutral distribution for the underlying stock price. Firms with concave IV curves exhibit significantly higher absolute stock returns on EAD and higher realized volatility after the announcement, rendering concavity an ex-ante signal for event risk. Returns on delta-neutral straddles, delta-neutral strangles, and delta- and vega-neutral calendar straddles are negative and significantly lower in the presence of concave IV curves, showing that investors pay a substantial premium to hedge against the gamma risk arising from this event.