Implied Volatility Spreads, Skewness and Expected Market Returns
Turan G. Bali
Georgetown University - Robert Emmett McDonough School of Business
K. Ozgur Demirtas
July 14, 2010
Georgetown McDonough School of Business Research Paper No. 1511970
This paper investigates the intertemporal relation between implied volatility spreads and expected returns on the aggregate stock market. The results show a signifi cantly negative link between expected future returns and the spread between the implied volatilities of out-of-the-money put and at-the-money call options written on the S&P 500 index. We argue that this relation is driven by information flow from option markets to stock markets rather than volatility spreads acting as a proxy for skewness. First, neither physical nor risk-neutral skewness can predict expected aggregate returns. Second, the relation between volatility spreads and expected market returns is signi ficantly stronger for the periods that S&P 500 constituent firms announce their earnings and for the periods that consumer sentiment index is extremely high or low. The intertemporal relation between volatility spreads and expected market returns remains strongly negative after controlling for various measures of conditional volatility, a large set of macroeconomic variables, small sample biases, and distributional assumptions.
Number of Pages in PDF File: 34
Keywords: implied volatility spreads, conditional skewness, expected market return, information flow, intertemporal risk-return relation
JEL Classification: G10, G11, G12, C13, E32, E37
Date posted: November 25, 2009 ; Last revised: July 2, 2016
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