Title: Option market (in)efficiency and implied volatility dynamics after return jumps,
Abstract: In informationally efficient financial markets, option prices and this
implied volatility should immediately be adjusted to new information that
arrives along with a jump in underlying's return, whereas gradual changes in
implied volatility would indicate market inefficiency. Using minute-by-minute
data on S&P 500 index options, we provide evidence regarding delayed and
gradual movements in implied volatility after the arrival of return jumps.
These movements are directed and persistent, especially in the case of negative
return jumps. Our results are significant when the implied volatilities are
extracted from at-the-money options and out-of-the-money puts, while the
implied volatility obtained from out-of-the-money calls converges to its new
level immediately rather than gradually. Thus, our analysis reveals that the
implied volatility smile is adjusted to jumps in underlying's return
asymmetrically. Finally, it would be possible to have statistical arbitrage in
zero-transaction-cost option markets, but under actual option price spreads,
our results do not imply abnormal option returns.