Option-Implied Network Measures of Tail Contagion and Stock Return Predictability
43 Pages Posted: 25 Feb 2021
Date Written: January 1, 2021
The Great Financial Crisis of 2008 – 2009 has raised the attention of policy-makers and researchers about the interconnectedness among the volatility of the returns of financial assets as a potential source of risk that extends beyond the usual changes in correlations and include transmission channels that operate through the higher order co-moments of returns. In this paper, we investigate whether a newly developed, forward-looking measure of volatility spillover risk based on option implied volatilities shows any predictive power for stock returns. We also compare the predictive performance of this measure with that of the volatility spillover index proposed by Diebold and Yilmaz (2008, 2012), which is based on realized, backward-looking volatilities instead. While both measures show evidence of in-sample predictive power, only the option-implied measure is able to produce out-of-sample forecasts that outperform a simple historical mean benchmark.
Keywords: connectedness, volatility networks, implied volatility, realized volatility, equity return predictability, spillover risk
JEL Classification: G12, G17
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