The Lehman analysis follows two paths. First, companies that it determined most likely to re-state earnings as a consequence of complying with the SEC order were found to have higher implied volatilities. Higher equity implied volatility, in this case, is an expression of higher investor uncertainty in the absence of information about corporate responses to the SEC order.
Next in its analysis, Lehman found that 715 of the 943 stocks falling under the order have higher implied volatilities on a single stock basis when compared with S&P 500 index implied volatility. This means investors are much more uncertain about compliance with the SEC order on an individual stock basis than they are with the order’s effect on the market taken as a whole, Lehman said
From the investors' viewpoint, the worst-case scenarios are that the SEC's review of corporate filings will ultimately lead to a re-statement of a company’s earnings, or that the company fails to comply with the order.
The Lehman team identified 15 companies out of 715 falling under the SEC order as most likely to re-state earnings, but declined to provide their names. The identification was made by measuring the difference between a company’s reported earnings per share and free cashflow per share. Lehman deems free cashflow as a more robust measure of real profitability than reported earnings per share. The larger the difference between the two, reasons the US investment bank, the more likely would be an earnings re-statement.
Lehman found that one-month, at-the-money option-implied volatility for the 15 stocks rose from 40% to 60% in late July, while in the same period the S&P 500’s implied volatility fell from 41% to 36%. Many of these companies were in the utilities and materials sectors, which in addition to financials also exhibited higher implied volatilities than the S&P 500.
After virtually identical histories prior to the June 28 order, 22-day realised volatility for the S&P 500 and a basket of 715 stocks that fall under the SEC order have diverged. The implied volatility spread between the two sets was as high as 25% in the first two weeks after the order, and has since climbed back up to 22% on July 30. According to Lehman there may be trading opportunities in the volatility spread before it falls on August 14, when information on which companies have complied with the SEC order is known. For example, one could sell select single-stock volatility and buy S&P 500 volatility, and earn the spread as the two converge.