Volatility Risk and Stock Return Predictability on Global Financial Crises

Abstract

This paper investigates the role of volatility risk on stock return predictability specified on two global financial crises: the dot-com bubble and recent financial crisis. Using a broad sample of stock options traded at the American Stock Exchange and the Chicago Board Options Exchange (CBOE) from January 2001 to December 2010, we examine different idiosyncratic volatility forecasting measures on future stock returns in four different periods (bear and bull markets). First we find clear and robust empirical evidence that the implied idiosyncratic volatility is the best stock return predictor for every sub periods both bear and bull markets. Second, the cross-section firm-specific characteristics are important on stock returns forecast in mixed positive and negative effects for bear and bull markets. Third, we provide evidence that short selling constraints impact negatively stock returns for only a bull market and liquidity is meaningless for both bear and bull markets after the recent financial crisis.