Volatility Spreads and Expected Stock Returns

This paper investigates whether realized and implied volatilities of individual stocks can predict the cross-sectional variation in expected returns. Although the levels of volatilities from the physical and risk-neutral distributions cannot predict future returns, there is a significant relation be...

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Bibliographic Details
Published in:Management science 2009-11, Vol.55 (11), p.1797-1812
Main Authors: Bali, Turan G, Hovakimian, Armen
Format: Article
Language:English
Subjects:
Analysis
Applied sciences
Arbitrage
Bids
Exact sciences and technology
Expected returns
Financial portfolios
GARCH models
implied volatility
Information management
Investment analysis
Investment risk
Investments
Investors
jump risk
Linear inference, regression
Management science
Mathematics
Operational research and scientific management
Operational research. Management science
Options (Finance)
Options trading
Portfolio theory
Price formation
Price volatility
Probability and statistics
Put & call options
Rates of return
realized volatility
Regression analysis
Risk premiums
Sciences and techniques of general use
Securities prices
Skewed distribution
Skewness
Spread
Statistical variance
Statistics
Stochastic models
Stock exchange
Stock exchanges
Stock options
Stock prices
Stock returns
Stocks
Studies
Volatility
volatility risk
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Description
Summary:This paper investigates whether realized and implied volatilities of individual stocks can predict the cross-sectional variation in expected returns. Although the levels of volatilities from the physical and risk-neutral distributions cannot predict future returns, there is a significant relation between volatility spreads and expected stock returns. Portfolio level analyses and firm-level cross-sectional regressions indicate a negative and significant relation between expected returns and the realized-implied volatility spread that can be viewed as a proxy for volatility risk. The results also provide evidence for a significantly positive link between expected returns and the call-put options' implied volatility spread that can be considered as a proxy for jump risk. The parameter estimates from the VAR-bivariate-GARCH model indicate significant information flow from individual equity options to individual stocks, implying informed trading in options by investors with private information.
ISSN:0025-1909
1526-5501
DOI:10.1287/mnsc.1090.1063