Abstract
We propose an implied volatility index for Brazil (called IVol-BR), based on daily market prices of options over IBOVESPA - an option market with relatively low liquidity and low number of option strikes. Our methodology combines usual international methodology used in high-liquidity markets with adjustments that take into account the low liquidity in Brazilian option market. We do a number of empirical tests to validate the IVol-BR. First, we show that the IVol-BR has significant predictive power over future volatility of equity returns not contained in traditional volatility forecasting variables. Second, we decompose the squared IVol-BR into (i) the expected variance of stock returns and (ii) the equity variance premium. This decomposition is of interest since the equity variance premium directly relates to the representative investor risk-aversion. Finally, we show empirically that higher risk-aversion is accompanied with higher expected returns, confirming the theory that high risk-aversion should be compensated by higher returns.
Highlights
This is the first article to propose an implied volatility index for the stock market in Brazil.1 We call our implied volatility index “IVol-BR”
If the variance premium positively comoves with investors risk-aversion, it should predict future market returns: when risk aversion is high, prices are low; consequentially, future returns should be high
The results are largely robust to the selection of the variance model. This is the first article to propose an implied volatility index for the Brazilian stock market based on option and futures prices traded locally
Summary
This is the first article to propose an implied volatility index for the stock market in Brazil. We call our implied volatility index “IVol-BR”. Based on the results using a sample from 2011 to 2015, we show that both the risk aversion measure and the variance premium are good predictors of future stock returns in Brazil.3 This is the second contribution of this paper. The squared implied volatility (which is directly computed from option prices) has a premium with respect to the (empirical) expected variance: the first should always be higher than the second.
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