Options trades, short sales and real earnings management

Abstract

We study the link between measures of stock options’ volatility and firms’ real earnings management (RM). We hypothesise that RM causes uncertainty in the value of a firm’s common stock and, as a result, increases the volatility spread and skew of the firm’s options. Spread and skew proxy for investors’ uncertainty in the value of the options underlying a stock. Consistent with our hypothesis, we find an association between a firm’s use of RM, and the volatility spread and skew in the firm’s options, more precisely in its put options. We also study the link between short selling and the extent of RM but do not find a consistent relationship between the two.