Abstract
This paper investigates the role of volatility risk on stock return predictability. Using 596 stock options traded at the American Stock Exchange and the Chicago Board Options Exchange (CBOE) for the period from January 2001 to December 2010, it examines the relation between different idiosyncratic volatility measures and expected stock returns for a period that involves both the dotcom bubble and the recent financial crisis. First it is showed that implied idiosyncratic volatility is the best stock return predictor among the different volatility measures used. Second, cross-section firm-specific characteristics are important on stock returns forecast. Third, we provide evidence that higher short selling constraints impact negatively stock returns having liquidity the opposite effect.
Highlights
Volatility is recognized to be central in asset pricing
We examine the role of volatility risk in stock returns predictability for 596 stock options traded at the American Stock Exchange and the Chicago Board Options Exchange (CBOE) for the period from January 2001 to December 2010
The sample represents the US equity option market by comprising the stock options traded at the American Stock Exchange and the Chicago Board Options Exchange (CBOE) for the period from January 2001 to December 2010
Summary
Volatility is recognized to be central in asset pricing. An accurate forecast of future volatility delivers important information to market participants and, options can be essentially bet on volatility. Financial market volatility is important to option pricing and a vital input for investment and financial market regulation. The volatile market environment and depressed expected returns of the past several years have increased the use of volatility strategies. No investor wants to be exposed to unnecessary risks that are not compensated by a return premium. There is an extensive literature on volatility prediction and broadly the best forecast of future volatility is the market’s prediction imbedded in implied volatility. Investors are looking to diversify their portfolio strategy in recent years, becoming volatility a new asset class.
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