Investigating the Intertemporal Relation between Volatility Spreads and Expected Returns
Turan G. Bali
Georgetown University - Robert Emmett McDonough School of Business
K. Ozgur Demirtas
CUNY Baruch College - Zicklin School of Business
July 15, 2011
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, C13working papers series
Date posted: July 16, 2011 ; Last revised: May 24, 2012
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