The Relationship between the Option-implied Volatility Smile, Stock Returns and Heterogeneous Beliefs

Authors

Shu Feng, Clark UniversityFollow
Yi Zhang, Prairie View A&M UniversityFollow
Geoffrey C. Friesen, University of Nebraska-LincolnFollow

Date of this Version

7-1-2015

Citation

Published in International Review of Financial Analysis 41 (2015), pp. 62–73; doi: 10.1016/j.irfa.2015.05.027

Comments

Copyright © 2015 Shu Feng, Yi Zhang, and Geoffrey C. Friesen. Published by Elsevier Inc. Used by permission.

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.