Investigating the Intertemporal Relation between Volatility Spreads and Expected Returns

Abstract:     
This paper investigates the intertemporal relation between volatility spreads and expected returns on the aggregate stock market. We show that the significantly… negative link between volatility spreads and expected returns is driven by information flow from options to stock market rather than volatility spreads acting as a proxy for skewness. First, neither physical nor risk-neutral skewness can predict aggregate stock returns. Second, the relation is significantly stronger for the periods that (i) S&P 500 constituent …firms announce their earnings; (ii) cash flow and discount rate news are large in magnitude; and (iii) consumer sentiment index is extremely high or low. Moreover, the intertemporal relation remains strongly negative after controlling for conditional volatility, variance risk premium, and macroeconomic variables.

Number of Pages in PDF File: 50

Keywords: expected market returns, volatility spreads, variance risk premia, information based explanation

JEL Classification: G10, G12, C13

working papers series