Belief Heterogeneity in the Option Markets and the Cross-Section of Stock Returns

62 Pages Posted: 20 Jan 2016 Last revised: 7 Mar 2019

See all articles by Paul Borochin

Paul Borochin

University of Miami - Department of Finance

Yanhui Zhao

University of Wisconsin - Whitewater - College of Business and Economics

Date Written: March 4, 2019

Abstract

Standard deviations of the volatility premium, of implied volatility innovations, and of the volatility term structure spread in equity options help explain the cross-section of one-month-ahead underlying stock returns. The explanatory power from standard deviations is robust to the levels of these three variables, volatility of volatility, firm characteristics, and common risk factor models. We find support for interpreting the standard deviations of these option-based measures as forward-looking proxies of heterogeneous beliefs. The negative relationship between our three measures and future underlying returns is consistent with the Miller (1977) overvaluation model which implies that divergence of investor opinions in the presence of short-sale constraints leads to lower expected returns.

Keywords: Options; Implied Volatility; Belief Heterogeneity

JEL Classification: G13, G14

Suggested Citation

Borochin, Paul and Zhao, Yanhui, Belief Heterogeneity in the Option Markets and the Cross-Section of Stock Returns (March 4, 2019). Available at SSRN: https://ssrn.com/abstract=2717752 or http://dx.doi.org/10.2139/ssrn.2717752

Paul Borochin (Contact Author)

University of Miami - Department of Finance ( email )

P.O. Box 248094
Coral Gables, FL 33124-6552
United States

Yanhui Zhao

University of Wisconsin - Whitewater - College of Business and Economics ( email )

Whitewater, WI 53190
United States

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