Volatility Noise

74 Pages Posted: 6 Mar 2018 Last revised: 6 Dec 2018

See all articles by Michael Hofmann

Michael Hofmann

Karlsruhe Institute of Technology (KIT) - Institute for Finance

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance

Date Written: December 4, 2018

Abstract

This study shows that fitting errors of equity-option-implied volatility surfaces are informative about intermediary frictions. For each stock and day, we quantify the goodness of fit between the observed implied volatilities of all available options and the corresponding estimates from OptionMetrics’ smoothed volatility surface using root-mean-square errors. In the cross-section of stocks, this error metric increases in idiosyncratic stock volatility and several measures of option and stock illiquidity. Based on these insights, we propose an overarching measure for intermediary frictions given by the value-weighted average of the stock-specific fitting errors. This measure of volatility noise peaks during episodes of market distress and exhibits sensible correlations to standard economic state variables like the market return, the TED spread, or the VIX. Moreover, we uncover a close link between volatility noise and the constraints on intermediary equity and debt. Finally, our asset pricing results indicate that volatility noise is informative for the cross-sectional variation in expected returns beyond the equity option market. In particular, we find volatility noise to constitute a priced risk factor in returns of stocks as well as equity and bond mutual funds.

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

JEL Classification: G10, G12, G13

Suggested Citation

Hofmann, Michael and Uhrig-Homburg, Marliese, Volatility Noise (December 4, 2018). Available at SSRN: https://ssrn.com/abstract=3130045 or http://dx.doi.org/10.2139/ssrn.3130045

Michael Hofmann (Contact Author)

Karlsruhe Institute of Technology (KIT) - Institute for Finance ( email )

P.O. Box 6980
D-76049 Karlsruhe
Germany
+49 721 6084 8185 (Phone)
+49 721 6084 8190 (Fax)

HOME PAGE: http://derivate.fbv.kit.edu/english/index.php

Marliese Uhrig-Homburg

Karlsruhe Institute of Technology (KIT) - Institute for Finance ( email )

P.O. Box 6980
D-76049 Karlsruhe, DE
Germany
+49 721 6084 8183 (Phone)
+49 721 6084 8190 (Fax)

HOME PAGE: http://derivate.fbv.kit.edu/english/index.php

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