Risk-return relationship and information content of implied and realized volatility
Abstract
The capital asset pricing model (CAPM), Arbitrage Pricing Theory (APT), and Fama & French’s three-factor model (FF3F) all assume a positive linear risk-return relationship. Findings of the contrary are deemed anomalous. In this thesis, I use portfolio sorts of short-term, long-term, and trade-weighted implied volatilities and their corresponding realized volatility as the main methodological framework. I investigate: i) the presence of a low-volatility anomaly, and whether it can be exploited. ii) Difference in risk-return relationship between realized and implied volatility, and iii) the predictive power of the call-put implied volatility spread and volatility risk premium on future stock returns. To my knowledge trade-weighted implied volatility has not been used before in such analysis, and my analyzed sample-period of 2009-2023 provides an update of previous findings on these topics. I find that i) the low-volatility anomaly is present but cannot be exploited. ii) Trade-weighted implied volatility gives the most theoretically consistent risk-return relationship out of all measures analyzed, and iii) the call-put implied volatility spread of short-term options predicts future stock returns.