Volatility Spreads and Expected Stock Returns

33 Pages Posted: 12 Nov 2007  

Turan G. Bali

Georgetown University - Robert Emmett McDonough School of Business

Armen Hovakimian

Baruch College - Zicklin School of Business

Multiple version iconThere are 2 versions of this paper

Date Written: November 2007

Abstract

We examine the relation between expected future volatility (options' implied volatility) and the cross-section of expected returns. A trading strategy buying stocks in the highest implied volatility quintile and shorting stocks in the lowest implied volatility quintile generates insignificant returns. A similar strategy using one-month lagged realized volatility generates significantly negative returns. To investigate the differences and interactions between alternative measures of total risk, we estimate three principal components based on realized volatility, call implied and put implied volatility. Long-short trading strategies generate significant returns only for the second and the third principal components. We find that the second principal component is related to the realized-implied volatility spread which can be viewed as a proxy for volatility risk. We find that the third principal component is related to the call-put implied volatility spread that reflects future price increase of the underlying stock.

Keywords: expected returns, implied volatility, realized volatility, volatility spread

JEL Classification: G12, G13, G14

Suggested Citation

Bali, Turan G. and Hovakimian, Armen, Volatility Spreads and Expected Stock Returns (November 2007). Available at SSRN: https://ssrn.com/abstract=1029197 or http://dx.doi.org/10.2139/ssrn.1029197

Turan G. Bali (Contact Author)

Georgetown University - Robert Emmett McDonough School of Business ( email )

3700 O Street, NW
Washington, DC 20057
United States
(202) 687-5388 (Phone)
(202) 687-4031 (Fax)

HOME PAGE: http://faculty.msb.edu/tgb27/

Armen Hovakimian

Baruch College - Zicklin School of Business ( email )

One Bernard Baruch Way
Box B10-225
New York, NY 10010
United States
646-312-3490 (Phone)
646-312-3451 (Fax)

HOME PAGE: http://faculty.baruch.cuny.edu/ahovakimian/

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