The Information Content in Implied Idiosyncratic Volatility and the Cross-Section of Stock Returns: Evidence from the Option Markets

Abstract

Current literature is inconclusive as to whether idiosyncratic risk influences future stock returns and the direction of the impact. Prior studies are based on historical realized volatility. Implied volatilities from option prices represent the market's assessment of future risk and are likely a superior measure to historical realized volatility. We use implied idiosyncratic volatilities on firms with traded options to examine the relation between idiosyncratic volatility and future returns. We find a strong positive link between implied idiosyncratic risk and future returns. After considering the impact of implied idiosyncratic volatility, historical realized idiosyncratic volatility is unimportant. This performance is strongly tied to small size and high book-to-market equity firms.

Keywords: implied volatility, idiosyncratic volatility, portfolio returns

JEL Classification: G11, G12