Do Implied Volatilities Provide Early Warning of Market Stress?

Abstract

Implied volatility can signal that market turmoil has become more likely in the near future. Statistical evidence is presented indicating that implied volatility contains information regarding future large-magnitude returns which is not contained in other risk measures. Large moves in asset prices are often preceded by significant increases in implied volatility. A practical warning signal based on implied volatility that can help risk managers posture themselves for stress events is developed.

JEL Classification: F3, G13, G14