Hostname: page-component-77c89778f8-rkxrd Total loading time: 0 Render date: 2024-07-16T09:23:18.136Z Has data issue: false hasContentIssue false
  • English
  • Français

The Only Constant Is Change: Nonconstant Volatility and Implied Volatility Spreads

Published online by Cambridge University Press:  27 February 2023

T. Colin Campbell ,
Michael Gallmeyer  and
Alex Petkevich
T. Colin Campbell
Affiliation:
University of Cincinnati Lindner College of Business campbtt@ucmail.uc.edu
Michael Gallmeyer
Affiliation:
University of Virginia McIntire School of Commerce and University of Melbourne Faculty of Business and Economics mgallmeyer@virginia.edu
Alex Petkevich*
Affiliation:
University of Denver Daniels College of Business
*
alexey.petkevich@du.edu (corresponding author)
Get access Rights & Permissions [Opens in a new window]

Abstract

We examine the predictability of stock returns using implied volatility spreads (VS) from individual (nonindex) options. VS can occur under simple no-arbitrage conditions for American options when volatility is time-varying, suggesting that the VS-return predictability could be an artifact of firms’ sensitivities to aggregate volatility. Examining this empirically, we find that the predictability changes systematically with aggregate volatility and is positively related to the firms’ sensitivities to volatility risk. The alpha generated by VS hedge portfolios can be explained by aggregate volatility risk factors. Our results cannot be explained by firm-specific informed trading, transaction costs, or liquidity.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 58 , Issue 5 , August 2023 , pp. 2190 - 2227
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

We thank Hendrik Bessembinder (the editor), Doina Chichernea, Martijn Cremers (a referee), Hui Guo, Burton Hollifield, Kershen Huang, Haim Kassa, J. Spencer Martin, Sachin Modi, Pamela Moulton, Dmitriy Muravyev, Scott Murray, David Ng, Ralitsa Petkova, Ivan Shaliastovich, Yuhang Xing (a referee), participants at the 2013 Financial Management Association Meeting, and participants at research seminars at Curtin University, Florida International University, Rochester Institute of Technology, and the University of Western Australia for helpful comments. Any remaining errors or omissions are the authors’ alone.

References

Amin, K.; Coval, J. D.; and Seyhun, H. N.. “Index Option Prices and Stock Market Momentum.” Journal of Business, 77 (2004), 835–874.10.1086/422440CrossRefGoogle Scholar
Amin, K. I., and Lee, C. M. C.. “Option Trading, Price Discovery, and Earnings News Dissemination.” Contemporary Accounting Research, 14 (1997), 153–192.10.1111/j.1911-3846.1997.tb00531.xCrossRefGoogle Scholar
An, B.-J.; Ang, A.; Bali, T. G.; and Cakici, N.. “The Joint Cross Section of Stocks and Options.” Journal of Finance, 69 (2014), 2279–2337.CrossRefGoogle Scholar
Anderson, C., and Garcia-Feijoo, L.. “Empirical Evidence on Capital Investment, Growth Options, and Security Returns.” Journal of Finance, 61 (2006), 171–194.CrossRefGoogle Scholar
Ang, A.; Chen, J.; and Xing, Y.. “Downside Risk.” Review of Financial Studies, 19 (2006a), 1191–1239.CrossRefGoogle Scholar
Ang, A.; Hodrick, R. J.; Xing, Y.; and Zhang, X.. “The Cross-Section of Volatility and Expected Returns.” Journal of Finance, 61 (2006b), 259–299.10.1111/j.1540-6261.2006.00836.xCrossRefGoogle Scholar
Arisoy, Y. “Aggregate Volatility and Market Jump Risk: An Option-Based Explanation to Size and Value Premia.” Journal of Futures Markets, 34 (2014), 34–55.CrossRefGoogle Scholar
Atilgan, Y. “Volatility Spreads and Earnings Announcement Returns.” Journal of Banking and Finance, 38 (2014), 205–215.10.1016/j.jbankfin.2013.10.007CrossRefGoogle Scholar
Bakshi, G.; Cao, C.; and Chen, Z.. “Empirical Performance of Alternative Option Pricing Models.” Journal of Finance, 52 (1997), 2003–2049.10.1111/j.1540-6261.1997.tb02749.xCrossRefGoogle Scholar
Bansal, R., and Yaron, A.. “Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles.” Journal of Finance, LIX (2004), 1481–1509.CrossRefGoogle Scholar
Barinov, A. “Aggregate Volatility Risk: Explaining the Small Growth Anomaly and the New Issues Puzzle.” Journal of Corporate Finance, 18 (2012), 763–781.10.1016/j.jcorpfin.2012.05.005CrossRefGoogle Scholar
Barinov, A. “Analyst Disagreement and Aggregate Volatility Risk.” Journal of Financial and Quantitative Analysis, 48 (2013), 1877–1900.10.1017/S002210901400009XCrossRefGoogle Scholar
Barinov, A., and Wu, J. J.. “Short Interest and Aggregate Volatility Risk.” Working Paper, University of Georgia (2013).CrossRefGoogle Scholar
Bates, D. S. “The Crash of ’87: Was It Expected? The Evidence from Options Markets.” Journal of Finance, 46 (1991), 1009–1044.CrossRefGoogle Scholar
Battalio, R., and Schultz, P.. “Options and the Bubble.” Journal of Finance, 61 (2006), 2071–2102.10.1111/j.1540-6261.2006.01051.xCrossRefGoogle Scholar
Bekaert, G., and Wu, G.. “Asymmetric Volatility and Risk in Equity Markets.” Review of Financial Studies, 13 (2000), 1–42.10.1093/rfs/13.1.1CrossRefGoogle Scholar
Berk, J.; Green, R.; and Naik, V.. “Optimal Investment, Growth Options, and Security Returns.” Journal of Finance, 54 (1999), 1553–1607.CrossRefGoogle Scholar
Black, F., “Studies of Stock Price Volatility Changes.” Proceedings of the 1976 Meetings of the American Statistical Association, Business and Economical Statistics Section (1976).Google Scholar
Black, F., and Scholes, M.. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy, 81 (1973), 637–654.10.1086/260062CrossRefGoogle Scholar
Bollerslev, T.; Li, S.; and Zhao, B., “Good Volatility, Bad Volatility, and the Cross-Section of Stock Returns.” Working Paper, Duke University (2017).Google Scholar
Bollerslev, T.; Tauchen, G.; and Zhou, H.. “Expected Stock Returns and Variance Risk Premia.” Review of Financial Studies, 22 (2009), 4463–4492.10.1093/rfs/hhp008CrossRefGoogle Scholar
Broadie, M.; Chernov, M.; and Johannes, M.. “Model Specification and Risk Premia: Evidence from Futures Options.” Journal of Finance, 62 (2007), 1453–1490.10.1111/j.1540-6261.2007.01241.xCrossRefGoogle Scholar
Campbell, J. Y. “Intertemporal Asset Pricing Without Consumption Data.” American Economic Review, 83 (1993), 487–512.Google Scholar
Campbell, J. Y. “Understanding Risk and Return.” Journal of Political Economy, 104 (1996), 298–345.CrossRefGoogle Scholar
Campbell, J. Y., and Hentschel, L.. “No News Is Good News: An Asymmetric Model of Changing Volatility in Stock Returns.” Journal of Financial Economics, 31 (1992), 281–318.CrossRefGoogle Scholar
Cao, C.; Chen, Z.; and Griffin, J. M.. “Informational Content of Option Volume Prior to Takeovers.” Journal of Business, 78 (2005), 1073–1109.CrossRefGoogle Scholar
Carhart, M. “On Persistence in Mutual Fund Performance.” Journal of Finance, 52 (1997), 57–82.CrossRefGoogle Scholar
Chernov, M., and Ghysels, E.. “A Study Towards a Unified Approach to the Joint Estimation of Objective and Risk Neutral Measures for the Purpose of Options Valuation.” JFE, 56 (2000), 407–458.CrossRefGoogle Scholar
Christie, A. A. “The Stochastic Behavior of Common Stock Variances: Value, Leverage, and Interest Rate Effects.” Journal of Financial Economics, 10 (1982), 407–432.CrossRefGoogle Scholar
Cox, J. C., and Ross, S. A.. “The Valuation of Options for Alternative Stochastic Processes.” Journal of Financial Economics, 3 (1976), 145–166.10.1016/0304-405X(76)90023-4CrossRefGoogle Scholar
Cox, J. C.; Ross, S. A.; and Rubinstein, M.. “Option Pricing: A Simplified Approach.” Journal of Financial Economics, 7 (1979), 229–263.CrossRefGoogle Scholar
Cremers, M.; Halling, M.; and Weinbaum, D.. “Aggregate Jump and Volatility Risk in the Cross-Section of Stock Returns.” Journal of Finance, 70 (2015), 577–614.CrossRefGoogle Scholar
Cremers, M., and Weinbaum, D.. “Deviations from Put-Call Parity and Stock Return Predictability.” Journal of Financial and Quantitative Analysis, 45 (2010), 335–367.CrossRefGoogle Scholar
Daniel, K.; Grinblatt, M.; Titman, S.; and Wermers, R.. “Measuring Mutual Fund Performance with Characteristic-Based Benchmarks.” Journal of Finance, 52 (1997), 1035–1058.10.1111/j.1540-6261.1997.tb02724.xCrossRefGoogle Scholar
Daniel, K.; Hirshleifer, D.; and Subrahmanyam, A.. “Investor Psychology and Security Market Under- and Overreactions.” Journal of Finance, 53 (1998), 1839–1885.10.1111/0022-1082.00077CrossRefGoogle Scholar
Delisle, R. J.; Doran, J. S.; and Peterson, D. R.. “Asymmetric Pricing of Implied Systematic Volatility in the Cross-Section of Expected Returns.” Journal of Futures Markets, 31 (2011), 34–54.CrossRefGoogle Scholar
Dennis, P.; Mayhew, S.; and Stivers, C.. “Stock Returns, Implied Volatility Innovations, and the Asymmetric Volatility Phenomenon.” Journal of Financial and Quantitative Analysis, 41 (2006), 381–406.CrossRefGoogle Scholar
Detzel, A. L.; Duarte, J.; Kamara, A.; Siegel, S.; and Sun, C.. “The Cross-Section of Volatility and Expected Returns: Then and Now.” Critical Finance Review, forthcoming (2023).CrossRefGoogle Scholar
Duffee, G. R. “Stock Returns and Volatility a Firm-Level Analysis.” Journal of Financial Economics, 37 (1995), 399–420.CrossRefGoogle Scholar
Easley, D.; O’Hara, M.; and Srinivas, P.. “Option Volume and Stock Prices: Evidence on Where Informed Traders Trade.” Journal of Finance, 53 (1998), 431–465.CrossRefGoogle Scholar
Fama, E., and French, K.. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33 (1993), 3–56.CrossRefGoogle Scholar
Fama, E. F., and MacBeth, J. D.. “Risk, Return, and Equilibrium: Empirical Tests.” Journal of Political Economy, 81 (1973), 607.CrossRefGoogle Scholar
Figlewski, S., and Webb, G. P.. “Options, Short Sales, and Market Completeness.” Journal of Finance, 48 (1993), 761–777.10.1111/j.1540-6261.1993.tb04738.xCrossRefGoogle Scholar
French, K.; Schwert, G. W.; and Stambaugh, R.. “Expected Stock Returns and Volatility.” Journal of Financial Markets, 19 (1987), 3–29.Google Scholar
Garleanu, N.; Pedersen, L. H.; and Poteshman, A. M.. “Demand-Based Option Pricing.” Review of Financial Studies, 22 (2009), 4259–4299.CrossRefGoogle Scholar
Harvey, C. R., and Siddique, A.. “Conditional Skewness in Asset Pricing Tests.” Journal of Finance, 55 (2000), 1263–1295.CrossRefGoogle Scholar
Heston, S. L. “A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options.” Review of Financial Studies, 6 (1993a), 327–343.10.1093/rfs/6.2.327CrossRefGoogle Scholar
Heston, S. L. “Invisible Parameters in Option Prices.” Journal of Finance, 48 (1993b), 933–947.10.1111/j.1540-6261.1993.tb04025.xCrossRefGoogle Scholar
Hull, J., and White, A.. “The Pricing of Options on Assets with Stochastic Volatilities.” Journal of Finance, 42 (1987), 281–300.CrossRefGoogle Scholar
Mashruwala, C.; Rajgopal, S.; and Shevlin, T.. “Why is the Accrual Anomaly Not Arbitraged Away? The Role of Idiosyncratic Risk and Transaction Costs.” Journal of Accounting and Economics, 42 (2006), 3–33.10.1016/j.jacceco.2006.04.004CrossRefGoogle Scholar
Melino, A., and Turnbull, S. M.. “Pricing Foreign Currency Options with Stochastic Volatility.” Journal of Econometrics, 45 (1990), 239–265.CrossRefGoogle Scholar
Merton, R. C. “Option Pricing When Underlying Stock Returns are Discontinuous.” Journal of Finance, 3 (1974), 125–144.Google Scholar
Muravyev, D.; Pearson, N. D.; and Pollet, J. M.. “Why Do Price and Volatility Information from the Options Market Predict Stock Returns?” Available at SSRN 2851560 (2018).Google Scholar
Newey, W. K., and West, K. D.. “Automatic Lag Selection in Covariance Matrix Estimation.” Review of Economic Studies, 61 (1994), 631–653.CrossRefGoogle Scholar
Pan, J. “The Jump-Risk Premia Implicit in Options: Evidence from an Integrated Time-Series Study.” Journal of Financial Economics, 63 (2002), 3–50.10.1016/S0304-405X(01)00088-5CrossRefGoogle Scholar
Pan, J., and Poteshman, A.. “The Information in Option Volume for Future Stock Prices.” Review of Financial Studies, 19 (2006), 871–908.CrossRefGoogle Scholar
Petkova, R., and Zhang, L.. “Is Value Riskier than Growth.” Journal of Financial Economics, 78 (2005), 187–202.CrossRefGoogle Scholar
Schwert, G. W. “Why Does Stock Market Volatility Change over Time?” Journal of Finance, 44 (1989), 1115–1153.CrossRefGoogle Scholar
Stivers, C. “Firm-Level Return Dispersion and the Future Volatility of Aggregate Stock Market Returns.” Journal of Financial Markets, 6 (2003), 389–411.CrossRefGoogle Scholar
Stivers, C., and Sun, L.. “Cross-Sectional Return Dispersion and Time-Variation in Value and Momentum Premia.” Journal of Financial and Quantitative Analysis, 45 (2010), 987–1014.CrossRefGoogle Scholar
Watanabe, A., and Watanabe, M.. “Time-Varying Liquidity Risk and the Cross Section of Stock Returns.” Review of Financial Studies, 21 (2008), 2449–2486.CrossRefGoogle Scholar
Wei, J. “Do Options Volatility Skew and Spread Really Predict Stock Returns?” Working Paper, University of Toronto (2014).Google Scholar
Wiggins, J. B. “Option Values Under Stochastic Volatility: Theory and Empirical Estimates.” Journal of Financial Economics, 19 (1987), 351–372.CrossRefGoogle Scholar
Xing, Y.; Zhang, X.; and Zhao, R.. “What Does the Individual Option Volatility Smirk Tell Us About Future Equity Returns?” Journal of Financial and Quantitative Analysis, 45 (2010), 641–662.CrossRefGoogle Scholar
Zhang, L. “The Value Premium.” Journal of Finance, 60 (2005), 67–103.10.1111/j.1540-6261.2005.00725.xCrossRefGoogle Scholar
Zhang, X. F. “Accruals, Investment, and the Accrual Anomaly.” Accounting Review, 82 (2007), 1333–1363.CrossRefGoogle Scholar
Supplementary material: PDF

Campbell et al. supplementary material

Campbell et al. supplementary material

Download Campbell et al. supplementary material(PDF)
PDF 348.4 KB