Implied Volatility Spreads and Expected Market Returns

Abstract:     
This paper investigates the intertemporal relation between volatility spreads and expected returns on the aggregate stock market. We provide evidence for a signi…cantly negative link between volatility spreads and expected returns at the daily and weekly frequencies. This link 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 signi…cantly stronger for the periods during which (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 takes extreme values. Moreover, the intertemporal relation remains strongly negative after controlling for conditional volatility, variance risk premium, and macroeconomic variables.

Number of Pages in PDF File: 53

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

JEL Classification: G10, G12, C13

working papers series