Option-Implied Network Measures of Tail Contagion and Stock Return Predictability

43 Pages Posted: 25 Feb 2021

See all articles by Manuela Pedio

Manuela Pedio

University of Bristol; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Date Written: January 1, 2021

Abstract

The Great Financial Crisis of 2008 – 2009 has raised the attention of policy-makers and researchers about the interconnectedness among the volatility of the returns of financial assets as a potential source of risk that extends beyond the usual changes in correlations and include transmission channels that operate through the higher order co-moments of returns. In this paper, we investigate whether a newly developed, forward-looking measure of volatility spillover risk based on option implied volatilities shows any predictive power for stock returns. We also compare the predictive performance of this measure with that of the volatility spillover index proposed by Diebold and Yilmaz (2008, 2012), which is based on realized, backward-looking volatilities instead. While both measures show evidence of in-sample predictive power, only the option-implied measure is able to produce out-of-sample forecasts that outperform a simple historical mean benchmark.

Keywords: connectedness, volatility networks, implied volatility, realized volatility, equity return predictability, spillover risk

JEL Classification: G12, G17

Suggested Citation

Pedio, Manuela, Option-Implied Network Measures of Tail Contagion and Stock Return Predictability (January 1, 2021). BAFFI CAREFIN Centre Research Paper No. 2021-154, Available at SSRN: https://ssrn.com/abstract=3791467 or http://dx.doi.org/10.2139/ssrn.3791467

Manuela Pedio (Contact Author)

University of Bristol ( email )

University of Bristol,
Senate House, Tyndall Avenue
Bristol, Avon BS8 ITH
United Kingdom

Bocconi University - CAREFIN - Centre for Applied Research in Finance ( email )

Via Sarfatti, 25
Milan, 20136
Italy

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