Implied Volatility Spreads and Expected Market Returns

This article investigates the intertemporal relation between volatility spreads and expected returns on the aggregate stock market. We provide evidence for a significantly negative link between volatility spreads and expected returns at the daily and weekly frequencies. We argue that this link is dr...

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Bibliographic Details
Published in:Journal of business & economic statistics 2015-01, Vol.33 (1), p.87-101
Main Authors: Atilgan, Yigit, Bali, Turan G., Demirtas, K. Ozgur
Format: Article
Language:English
Subjects:
Information flow
Macroeconomics
Option markets
Rates of return
Risk premiums
Securities markets
Stock exchanges
Studies
Transaction costs
Volatility
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Summary:This article investigates the intertemporal relation between volatility spreads and expected returns on the aggregate stock market. We provide evidence for a significantly negative link between volatility spreads and expected returns at the daily and weekly frequencies. We argue that this link is driven by the information flow from option markets to stock markets. The documented relation is significantly stronger for the periods during which (i) S&P 500 constituent firms announce their earnings; (ii) cash flow and discount rate news are large in magnitude; and (iii) consumer sentiment index takes extreme values. The intertemporal relation remains strongly negative after controlling for conditional volatility, variance risk premium, and macroeconomic variables. Moreover, a trading strategy based on the intertemporal relation with volatility spreads has higher portfolio returns compared to a passive strategy of investing in the S&P 500 index, after transaction costs are taken into account.
ISSN:0735-0015
1537-2707
DOI:10.1080/07350015.2014.923776