Information Content of Aggregate Implied Volatility Spread

Abstract

Aggregate implied volatility spread (IVS), defined as the cross-sectional average difference in the implied volatilities of at-the-money call and put equity options, is significantly and positively related to future stock market returns at daily, weekly, monthly, to semiannual horizons. This return predictive power is incremental to existing return predictors and is significant both in sample and out of sample. Furthermore, IVS can forecast macroeconomic news up to one year ahead. The return predictability concentrates around macro news announcement. Common informed trading in equity options offers an integrated explanation for the ability of IVS to predict both future stock market returns and real economic activity.

Keywords: stock return predictability, implied volatility spread, macroeconomic forecasts, informed trading in options, limits to arbitrage

JEL Classification: G12, G13, G14, G17