Option Implied Volatility, Skewness, and Kurtosis and the Cross-Section of Expected Stock Returns

75 Pages Posted: 9 Sep 2013 Last revised: 13 Jan 2016

Turan G. Bali

Georgetown University - Robert Emmett McDonough School of Business

Jianfeng Hu

Singapore Management University - Lee Kong Chian School of Business

Scott Murray

Georgia State University

Date Written: January 1, 2016

Abstract

Motivated by the nature of asset pricing models, we investigate the cross-sectional relation between the market's ex-ante view of a stock's risk and the stock's ex-ante expected return. We demonstrate that an ex-ante measure of expected returns based on analyst price targets is highly related to the market's required rate of return. Using this measure, we show that ex-ante measures of volatility, skewness, and kurtosis derived from option prices are positively related to ex-ante expected returns. We then decompose the risk measures into systematic and unsystematic components and find that while expected returns are related to both systematic and unsystematic variance risk, only the unsystematic components of skewness and kurtosis are important for explaining the cross-section of expected stock returns. The results are consistent using two different approaches to measuring ex-ante risk and robust to controls for other variables related to stock returns and analyst bias.

Keywords: Risk-Neutral Moments, Option-Implied Risk, Ex-Ante Expected Stock Returns, Price Targets

JEL Classification: G11, G12, G13

Suggested Citation

Bali, Turan G. and Hu, Jianfeng and Murray, Scott, Option Implied Volatility, Skewness, and Kurtosis and the Cross-Section of Expected Stock Returns (January 1, 2016). Georgetown McDonough School of Business Research Paper. Available at SSRN: https://ssrn.com/abstract=2322945 or http://dx.doi.org/10.2139/ssrn.2322945

Turan G. Bali

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://msbonline.georgetown.edu/faculty-research/msf-faculty/turan-bali

Jianfeng Hu

Singapore Management University - Lee Kong Chian School of Business ( email )

50 Stamford Road
Singapore, 178899
Singapore
(+65) 68085477 (Phone)

Scott Murray (Contact Author)

Georgia State University ( email )

35 Broad Street
Atlanta, GA 30303-3083
United States

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