Firm Fundamentals and the Cross Section of Implied Volatility Shapes

We document empirically that firm fundamentals have explanatory power on the shape of the option implied volatility (IV) curve that is both economically and statistically significant. We find further that, after accounting for fundamentals, the associated IV process can generate overreaction in the long-term IV with respect to change in the short-term IV, and it can also allow a positive profit from at-the-money (ATM) straddle writing, explaining puzzling patterns of the literature. We also provide a simple model that links the IV to firm fundamentals and permits realistic IV curves, largely consistent with the empirical findings