Options-Implied Variance and Future Stock Returns
77 Pages Posted: 20 Aug 2011 Last revised: 17 May 2014
Date Written: February 1, 2014
Using options-implied variance, a forward-looking measure of conditional variance, we revisit the debate on the idiosyncratic risk-return relation. In both cross-sectional (for individual stocks) and time-series (for the market index) regressions, we find a negative relation between options-implied variance and future stock returns. Consistent with Miller’s (1977) divergence of opinion hypothesis, the negative relation gets stronger (1) for stocks with more stringent short-sale constraints or (2) when shorting stocks becomes more difficult. Moreover, the negative correlation of realized idiosyncratic variance or analyst forecast dispersion with future stock returns mainly reflects their close correlation with our conditional idiosyncratic variance measure.
Keywords: stock return predictability, implied variance, realized variance, CAPM, and ICAPM
JEL Classification: G1
Suggested Citation: Suggested Citation