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P. Borochin, Y. Zhao, “Variation of the Implied Volatility Function and Return Predictability”

P. Borochin, Y. Zhao, “Variation of the Implied Volatility Function and Return Predictability”

Abstract: The variation of the shape of the implied volatility function (IVF) has significant predictive power for future performance, above that previously documented for the shape of the IVF itself. We find that standard deviations of IV spreads describing the shape of the IVF over the current month are negatively correlated with next month’s realized returns. This effect is strongest during expansionary periods, during contractions this relation becomes weaker. Return predictability is strongest in small firms with the most variable IVFs, but IVF variability yields significant return predictability and cross-sectional variation even with size and liquidity controls. We find support for interpreting the volatility of the IVF as a proxy of heterogeneous beliefs. The realized return relationship we observe is consistent with the Miller (1977) result that divergence of opinions leads to lower expected returns.