What Does Individual Option Volatility Smirk Tell Us About Future Equity Returns?
Purdue University - Krannert School of Management
August 14, 2008
AFA 2009 San Francisco Meetings Paper
The shape of the volatility smirk has significant cross-sectional predictive power for future equity returns. Stocks exhibiting the steepest smirks in their traded options underperform stocks with the least pronounced volatility smirks in their options by around 10.9% per year on a risk-adjusted basis. This predictability persists for at least six months, and firms with the steepest volatility smirks are those experiencing the worst earnings shocks in the following quarter. The results are consistent with the notion that informed traders with negative news prefer to trade out-of-the-money put options, and that the equity market is slow in incorporating the information embedded in volatility smirks.
Number of Pages in PDF File: 38
Keywords: stock return predictability, option-implied volatility smirks, cross-sectional asset pricing
JEL Classification: G11, G12, G14
Date posted: March 26, 2008 ; Last revised: August 15, 2008