Volatility Spreads and Expected Stock Returns
Management Science, Forthcoming
32 Pages Posted: 4 Aug 2009
Date Written: June 17, 2009
This paper investigates whether realized and implied volatilities of individual stocks can predict the cross-sectional variation in expected returns. Although the levels of volatilities from the physical and risk-neutral distributions cannot predict future returns, there is a significant relation between volatility spreads and expected stock returns. Portfolio level analyses and firm-level cross-sectional regressions indicate a negative and significant relation between expected returns and the realized-implied volatility spread that can be viewed as a proxy for volatility risk. The results also provide evidence for a significantly positive link between expected returns and the call-put options’ implied volatility spread that can be considered as a proxy for jump risk. The parameter estimates from the VAR-bivariate- GARCH model indicate significant information flow from individual equity options to individual stocks, implying informed trading in options by investors with private information.
Keywords: realized volatility, implied volatility, volatility risk, jump risk, stock returns
JEL Classification: G10, G11, G12, G14
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