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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)
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Abstract

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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

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.

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