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INTRODUCTION
The option market reveals important information about investors' expectations of the underlying return distribution. Although considerable research has examined the informational content of index options, little is known about individual equity options. Using a complete sample of US equity options, we analyze the relationship between implied volatility and future-realized returns.
In the last three decades, several articles have documented a small degree of predictability in stock returns based on prior information, specifically at long horizons. In the long run, dividend yields on an aggregate stock portfolios predict returns with some success, as shown by Campbell and Shiller (1988); Fama and French (1988, 1993), as well as Goyal and Welch (2003). Additional variables found to have predictive power include the short-term interest rate (Fama and Schwert, 1977), spreads between long- and short-term interest rates (Campbell, 1987), stock market volatility (French et al, 1987), book-to-market ratios (Kothari and Shanken, 1997; Pontiff and Schall, 1998), dividend-payout and price-earnings ratios (Lamont, 1998), as well as measures related to analysts' forecasts (Lee et al, 1999). Baker and Wurgler (2000) detect a negative relationship between IPO activity and future-excess returns. Lettau and Ludvigson (2001) find evidence for predictability using a consumption wealth ratio. Recently, the relationship between historical volatility and stock returns has been addressed by a number of authors (for example, Goyal and Santa-Clara (2003); Bali et al (2005), and Ang et al (2006)).Goyal and Santa-Clara (2003) analyze the predictability of stock market returns with several risk measures. They find a significant positive relationship between the cross-sectional average stock variance and the return on the market, whereas the variance of the market has no forecasting power for the market return. However, Bali et al (2005) disagree with these findings.
They argue that the results are primarily driven by small stocks traded on the NASDAQ, and are therefore partially because of a liquidity premium. Moreover, the results do not hold for an extended sample period. Ang et al (2006) examine the pricing of aggregate volatility risk in the cross-section of stock returns. They find that stocks with high idiosyncratic volatility in the Fama and French three-factor model have very low average returns.
Option-implied volatility is different from most of the variables used for predicting stock returns in at least...