Biased Implied Volatilities and Dividend-Paying Stocks

Abstract

In this study, the author investigates the positive spread between option-implied and realized volatility (i.e., variance risk premiums) for dividend versus non-dividend-paying stocks. The author finds, unconditionally, dividend-paying stocks have lower implied volatilities and variance risk premiums compared with nonpayers. However, using subsamples based on implied volatility levels, the author documents that dividend-paying firms have higher conditional variance risk premiums relative to nonpaying firms. Stated differently, for the same level of implied volatility, the spread between implied and future realized volatilities is higher for firms that pay dividends compared with firms that do not. Multivariate tests suggest this result is not explained by option-implied skewness and kurtosis, a proxy for option mispricing, and fundamental risk factors. The results suggest that traders can generate higher risk-adjusted returns from shorting options on dividend-paying firms relative to nonpayers and investors should adjust dividend-paying firms’ implied volatilities down more compared with non-dividend-paying firms’ implied volatilities before performing portfolio optimizations.