Valuation and Returns on Stock Return Volatility

Abstract

This paper provides an accounting-based valuation model that predicts that cross-sectional variation in returns to investments in both stock and stock return volatility are related to cross-sectional variation in fundamentals. The model predicts that expected stock returns have a positive quadratic relation with stock return variance and a negative quadratic relation with gains to trading in stock return variance. Consistent with these predictions, firms with high model-implied expected stock returns have high future stock return variance, and the relation is roughly quadratic. In contrast, firms with high expected stock returns have low returns to trading in stock return variance through option contracts because these firms have high option-implied variance relative to future realized variance, i.e., low variance risk premia (VRP). The study provides a framework for jointly investing in stocks and options and highlights the ability of accounting-based valuation models to explain phenomena across stock and volatility markets.

Keywords: Fundamental Analysis, Valuation, Stock Returns, Variance Risk Premiums, Option Returns

JEL Classification: G12, G14, G17