The Joint Cross Section of Stocks and Options
Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)
Turan G. Bali
Georgetown University - Robert Emmett McDonough School of Business
March 1, 2010
AFA 2011 Denver Meetings Paper
Fordham University Schools of Business Research Paper No. 2010-003
Option volatilities have significant predictive power for the cross section of stock returns and vice versa. Stocks with large increases in call implied volatilities tend to rise over the following month whereas increases in put implied volatilities forecast future decreases in next-month stock returns. The spread in average returns and alphas between the first and fifth quintile portfolios formed by ranking on lagged changes in implied call volatilities is approximately 1% per month. Going in the other direction, stocks with high returns over the past month tend to have call option contracts that exhibit increases in implied volatility over the next month, but realized volatility tends to decrease. The results are consistent with the slow diffusion of information across option and underlying equity markets and are suggestive of informed trading occurring in both asset markets.
Number of Pages in PDF File: 58
Keywords: implied volatility, risk premiums, return predictability, momentum
JEL Classification: G10, G11, C13working papers series
Date posted: January 8, 2010 ; Last revised: February 27, 2012
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