Volatility Noise

Abstract

We investigate whether fitting errors of equity-option-implied volatility surfaces are related to asset-price movements. Relating observed implied volatilities to a smoothed volatility surface and aggregating across the stock universe, we obtain a market-wide measure, volatility noise (VN), whose properties suggest valuable and robust information on the severity of intermediary frictions. VN peaks during market distress, exhibits sensible correlations to economic state variables, and relates to intermediaries’ liquidity supply. VN is informative for the cross-sectional variation in expected returns beyond standard risk and friction factors. Its constituents, the stock-specific volatility deviations, give rise to a substantial level premium.

Keywords: equity options, implied volatility, intermediary asset pricing, frictions, cross-section of returns

JEL Classification: G10, G12, G13