75 Pages Posted: 9 Sep 2013 Last revised: 13 Jan 2016
Date Written: January 1, 2016
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: 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