Volatility Spreads and Expected Stock Returns

TLDR

Volatility spreads, rather than absolute volatility levels, are significantly related to expected stock returns. The study tests whether realized and implied volatilities of individual stocks predict cross‑sectional expected returns. Results reveal a negative association between expected returns and the realized‑implied volatility spread, a positive association with the call‑put implied spread, and that equity options transmit information to stock prices.

Abstract

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.