Jump Risk, Stock Returns, and Slope of Implied Volatility Smile

Abstract

In the presence of jump risk, expected stock return is a function of the average jump size, which can be proxied by the slope of option implied volatility smile. This implies a negative predictive relation between the slope of implied volatility smile and stock return, which is strongly supported by the empirical evidence. For over 4,000 stocks ranked by slope during 1996-2005, the difference between the risk-adjusted average returns of the lowest and highest quintile portfolios is 1.9% per month. Although both the systematic and idiosyncratic components of slope are priced, the idiosyncratic component dominates the systematic component in explaining the return predictability of slope. Our findings are robust after controlling for stock characteristics like size, book-to-market, leverage, volatility, skewness, and volume. Furthermore, the results cannot be explained by alternative measures of steepness of implied volatility smile in previous studies.