Does the Volatility-Hedging Portfolio Underreact to Volatility Innovations?

85 Pages Posted: 25 Apr 2022 Last revised: 27 Apr 2022

See all articles by Tong Wang

Tong Wang

University of Oklahoma, Price College of Business

Date Written: April 13, 2022

Abstract

This paper proposes a new explanation of the negative correlation between VIX betas and expected stock returns documented by Ang et al. (2006). While the relation has been widely cited as the proof that market volatility risk is priced in the cross-section of stocks, we find this view highly implausible because stocks with high VIX betas perform particularly poorly when the VIX index spikes up during the holding period. Also challenging the risk-based explanation is the finding that VIX betas only negatively predict stock returns if the betas are measured using intraday returns. We argue that the beta-return relation is indicative of market inefficiency and develop four theoretical models revolving around the conjecture that stocks with high VIX betas are overpriced because their prices underreact to innovations in market volatility. Further empirical tests show strong support for the underreaction-based explanations.

Keywords: volatility, underreaction, expected return, mispricing, factor model

JEL Classification: G11, G12, G13

Suggested Citation

Wang, Tong, Does the Volatility-Hedging Portfolio Underreact to Volatility Innovations? (April 13, 2022). Available at SSRN: https://ssrn.com/abstract=4083250 or http://dx.doi.org/10.2139/ssrn.4083250

Tong Wang (Contact Author)

University of Oklahoma, Price College of Business ( email )

307 West Brooks, Room 205A
Norman, OK 73019
United States
2132357250 (Phone)

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