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Estimating Expected Excess Returns Using Historical And Option‐Implied Volatility

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  • Charles J. Corrado
  • Thomas W. Miller

Abstract

We test the relation between expected and realized excess returns for the S&P 500 index from January 1994 through December 2003 using the proportional reward‐to‐risk measure to estimate expected returns. When risk is measured by historical volatility, we find no relation between expected and realized excess returns. In contrast, when risk is measured by option‐implied volatility, we find a positive and significant relation between expected and realized excess returns in the 1994–1998 subperiod. In the 1999–2003 subperiod, the option‐implied volatility risk measure yields a positive, but statistically insignificant, risk‐return relation. We attribute this performance difference to the fact that, in the 1994–1998 subperiod, return volatility was lower and the average return was much higher than in the 1999–2003 subperiod, thereby increasing the signal‐to‐noise ratio in the latter subperiod.

Suggested Citation

  • Charles J. Corrado & Thomas W. Miller, 2006. "Estimating Expected Excess Returns Using Historical And Option‐Implied Volatility," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 29(1), pages 95-112, March.
  • Handle: RePEc:bla:jfnres:v:29:y:2006:i:1:p:95-112
    DOI: 10.1111/j.1475-6803.2006.00168.x
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    References listed on IDEAS

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    1. Hui Guo & Robert F. Whitelaw, 2006. "Uncovering the Risk–Return Relation in the Stock Market," Journal of Finance, American Finance Association, vol. 61(3), pages 1433-1463, June.
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    Cited by:

    1. Kearney, Fearghal & Shang, Han Lin & Sheenan, Lisa, 2019. "Implied volatility surface predictability: The case of commodity markets," Journal of Banking & Finance, Elsevier, vol. 108(C).
    2. Yibing Chen & Cheng-Few Lee & John Lee & Jow-Ran Chang, 2018. "Alternative Methods to Estimate Implied Variance: Review and Comparison," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 21(04), pages 1-28, December.
    3. Dror Parnes, 2011. "Developments in corporate creditworthiness around ownership events," International Journal of Managerial Finance, Emerald Group Publishing Limited, vol. 7(4), pages 377-396, September.
    4. Ahmed, Mohamed S. & Alhadab, Mohammad, 2020. "Momentum, asymmetric volatility and idiosyncratic risk-momentum relation: Does technology-sector matter?," The Quarterly Review of Economics and Finance, Elsevier, vol. 78(C), pages 355-371.
    5. Bertrand B. Maillet & Jean-Philippe R. M�decin, 2010. "Extreme Volatilities, Financial Crises and L-moment Estimations of Tail-indexes," Working Papers 2010_10, Department of Economics, University of Venice "Ca' Foscari".
    6. Dunis, Christian & Kellard, Neil M. & Snaith, Stuart, 2013. "Forecasting EUR–USD implied volatility: The case of intraday data," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 4943-4957.
    7. Bertrand Maillet & Jean-Philippe Médecin & Thierry Michel, 2009. "High Watermarks of Market Risks," Post-Print halshs-00425585, HAL.
    8. Corrado, Charles J. & Jordan, Bradford D. & Miller, Thomas Jr. & Stansfield, John J., 2001. "Repricing and employee stock option valuation," Journal of Banking & Finance, Elsevier, vol. 25(6), pages 1059-1082, June.
    9. Konstantinidi, Eirini & Skiadopoulos, George & Tzagkaraki, Emilia, 2008. "Can the evolution of implied volatility be forecasted? Evidence from European and US implied volatility indices," Journal of Banking & Finance, Elsevier, vol. 32(11), pages 2401-2411, November.
    10. Parnes, Dror, 2007. "Time series patterns in credit ratings," Finance Research Letters, Elsevier, vol. 4(4), pages 217-226, December.
    11. Agrrawal, Pankaj & Borgman, Richard, 2010. "What Is Wrong with this Picture? A Problem with Comparative Return Plots on Finance Websites and a Bias Against Income-Generating Assets," EconStor Open Access Articles and Book Chapters, ZBW - Leibniz Information Centre for Economics, vol. 11(4), pages 195-210.
    12. Kearney, Fearghal & Murphy, Finbarr & Cummins, Mark, 2015. "An analysis of implied volatility jump dynamics: Novel functional data representation in crude oil markets," The North American Journal of Economics and Finance, Elsevier, vol. 33(C), pages 199-216.

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