Predicting the Equity Premium with the Implied Volatility Spread
53 Pages Posted: 1 Oct 2020 Last revised: 18 Nov 2020
Date Written: September 18, 2020
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: Suggested Citation