Implied Volatility Spreads and Expected Market Returns

Abstract

This paper investigates the intertemporal relation between volatility spreads and expected returns on the aggregate stock market. We provide evidence for a signi…ficantly negative link between volatility spreads and expected returns at the daily and weekly frequencies. We argue that this link is driven by the information ‡flow from option markets to stock markets. The documented relation is signi…ficantly stronger for the periods during which (i) S&P 500 constituent fi…rms announce their earnings; (ii) cash ‡flow and discount rate news are large in magnitude; and (iii) consumer sentiment index takes extreme values. The intertemporal relation remains strongly negative after controlling for conditional volatility, variance risk premium and macroeconomic variables. Moreover, a trading strategy based on the intertemporal relation with volatility spreads has higher portfolio returns compared to a passive strategy of investing in the S&P 500 index, after transaction costs are taken into account.

Keywords: expected market return, variance risk premium, implied volatility spreads, conditional skewness

JEL Classification: G10, G11, C13, E32, E37