Predicting the Equity Premium with the Implied Volatility Spread

53 Pages Posted: 1 Oct 2020 Last revised: 18 Nov 2020

See all articles by Charles Cao

Charles Cao

Pennsylvania State University

Timothy T. Simin

Pennsylvania State University

Han Xiao

Pennsylvania State University

Date Written: September 18, 2020

Abstract

We show that the call-put implied volatility spread (IVS) outperforms many well-known predictors of the U.S. equity premium at return horizons up to six months over the period from 1996:1 to 2017:12. The predictive ability of the IVS is unrelated to the dividend yield and is useful in explaining the cross-section of returns. Decomposing the IVS, we find the longer run predictive ability of the IVS operates primarily through a cash flow channel. We also find the IVS is significantly related to indicators of aggregate market direction and expected market conditions. Our results are consistent with the IVS reflecting market sentiment as well as information about informed trading.

Keywords: Implied volatility spread, Equity premium, Prediction

JEL Classification: G11, G12, G17

Suggested Citation

Cao, Charles and Simin, Timothy T. and Xiao, Han, Predicting the Equity Premium with the Implied Volatility Spread (September 18, 2020). Journal of Financial Markets, Vol.51, 2020, Available at SSRN: https://ssrn.com/abstract=3695262 or http://dx.doi.org/10.2139/ssrn.3695262

Charles Cao

Pennsylvania State University ( email )

Department of Finance
Smeal College of Business
University Park, PA 16802
United States
814-865-7891 (Phone)
814-865-3362 (Fax)

HOME PAGE: http://www.personal.psu.edu/qxc2/cao.html

Timothy T. Simin (Contact Author)

Pennsylvania State University ( email )

University Park, PA 16802
United States
814-865-3457 (Phone)

HOME PAGE: http://timsimin.net

Han Xiao

Pennsylvania State University ( email )

University Park, PA 16802
United States

HOME PAGE: http://han-xiao.weebly.com

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