Implied Volatility Spreads and Expected Market Returns

57 Pages Posted: 30 Jan 2012 Last revised: 28 Jul 2015

Yigit Atilgan

Sabanci University

Turan G. Bali

Georgetown University - Robert Emmett McDonough School of Business

K. Ozgur Demirtas

Sabanci University Graduate School of Management

Multiple version iconThere are 2 versions of this paper

Date Written: October 1, 2011

Abstract

This paper investigates the intertemporal relation between volatility spreads and expected returns on the aggregate stock market. We provide evidence for a significantly 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 significantly stronger for the periods during which (i) S&P 500 constituent firms 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 returns, volatility spreads, variance risk premia, information based explanation

JEL Classification: G10, G12, C13

Suggested Citation

Atilgan, Yigit and Bali, Turan G. and Demirtas, K. Ozgur, Implied Volatility Spreads and Expected Market Returns (October 1, 2011). Journal of Business and Economic Statistics, Vol. 33, No. 1, 2015. Available at SSRN: https://ssrn.com/abstract=1993289 or http://dx.doi.org/10.2139/ssrn.1993289

Yigit Atilgan

Sabanci University ( email )

Orta Mahalle ├ťniversite Caddesi 27
Istanbul, Orhanli, 34956 Tuzla 34956
Turkey

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/

K. Ozgur Demirtas

Sabanci University Graduate School of Management ( email )

Sabanci University, School of Management
Orhanli Tuzla
Orhanl─▒-Tuzla, Istanbul, 34956
Turkey
(+90) 216-483-9985 (Phone)
(+90) 216-483-9699 (Fax)

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