The relationship between the option-implied volatility smile, stock returns and heterogeneous beliefs

Shu Feng; Yi Zhang; Geoffrey C. Friesen

doi:10.1016/j.irfa.2015.05.027

The relationship between the option-implied volatility smile, stock returns and heterogeneous beliefs

Shu Feng, Yi Zhang, Geoffrey C. Friesen

Daugherty Water for Food Global Institute

Research output: Contribution to journal › Article › peer-review

7 Scopus citations

Abstract

We study the relationship between stock returns and the implied volatility smile slope of call and put options. Stocks with a steeper put slope earn lower future returns, while stocks with a steeper call slope earn higher future returns. Using dispersion of opinion as a proxy for belief differences, we find that the slope-stock return relation is strongest for stocks with high belief differences. The idiosyncratic component of the put slope fully explains the negative risk-adjusted stock returns. For the call slope, the idiosyncratic component dominates the systematic one, and explains the positive risk-adjusted returns.

Original language	English (US)
Pages (from-to)	62-73
Number of pages	12
Journal	International Review of Financial Analysis
Volume	41
DOIs	https://doi.org/10.1016/j.irfa.2015.05.027
State	Published - Oct 1 2015

Keywords

Heterogeneous beliefs
Implied volatility
Smile slope

ASJC Scopus subject areas

Finance
Economics and Econometrics

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10.1016/j.irfa.2015.05.027

Cite this

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title = "The relationship between the option-implied volatility smile, stock returns and heterogeneous beliefs",

abstract = "We study the relationship between stock returns and the implied volatility smile slope of call and put options. Stocks with a steeper put slope earn lower future returns, while stocks with a steeper call slope earn higher future returns. Using dispersion of opinion as a proxy for belief differences, we find that the slope-stock return relation is strongest for stocks with high belief differences. The idiosyncratic component of the put slope fully explains the negative risk-adjusted stock returns. For the call slope, the idiosyncratic component dominates the systematic one, and explains the positive risk-adjusted returns.",

keywords = "Heterogeneous beliefs, Implied volatility, Smile slope",

author = "Shu Feng and Yi Zhang and Friesen, {Geoffrey C.}",

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AU - Feng, Shu

AU - Zhang, Yi

AU - Friesen, Geoffrey C.

N1 - Funding Information: This research is supported by the summer research grant of College of Business at Prairie View A&M University and a summer research grant by the University of Nebraska- Lincoln. We thank the seminar participants at Prairie View A&M University and Southwestern Finance Association 2011 Meeting. Publisher Copyright: © 2015 .

PY - 2015/10/1

Y1 - 2015/10/1

N2 - We study the relationship between stock returns and the implied volatility smile slope of call and put options. Stocks with a steeper put slope earn lower future returns, while stocks with a steeper call slope earn higher future returns. Using dispersion of opinion as a proxy for belief differences, we find that the slope-stock return relation is strongest for stocks with high belief differences. The idiosyncratic component of the put slope fully explains the negative risk-adjusted stock returns. For the call slope, the idiosyncratic component dominates the systematic one, and explains the positive risk-adjusted returns.

AB - We study the relationship between stock returns and the implied volatility smile slope of call and put options. Stocks with a steeper put slope earn lower future returns, while stocks with a steeper call slope earn higher future returns. Using dispersion of opinion as a proxy for belief differences, we find that the slope-stock return relation is strongest for stocks with high belief differences. The idiosyncratic component of the put slope fully explains the negative risk-adjusted stock returns. For the call slope, the idiosyncratic component dominates the systematic one, and explains the positive risk-adjusted returns.

KW - Heterogeneous beliefs

KW - Implied volatility

KW - Smile slope

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The relationship between the option-implied volatility smile, stock returns and heterogeneous beliefs

Abstract

Keywords

ASJC Scopus subject areas

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