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Volatility Spreads and Expected Stock Returns

  • Turan G. Bali

    ()

    (Department of Economics and Finance, Zicklin School of Business, Baruch College, New York, New York 10010)

  • Armen Hovakimian

    ()

    (Department of Economics and Finance, Zicklin School of Business, Baruch College, New York, New York 10010)

Registered author(s):

    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.

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    File URL: http://dx.doi.org/10.1287/mnsc.1090.1063
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    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 55 (2009)
    Issue (Month): 11 (November)
    Pages: 1797-1812

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    Handle: RePEc:inm:ormnsc:v:55:y:2009:i:11:p:1797-1812
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