Option-Implied Variance Asymmetry and the Market Returns

This paper introduces an option-based market-level signal, termed Implied Variance Asymmetry from the method Three-Pass Regression Filter (IVA-3PRF). We find that IVA-3PRF is significantly positively correlated with future stock market returns, with a one standard deviation increase in IVA-3PRF corresponding to a 0.88% increase in stock market returns for the subsequent month. The predicted returns from IVA-3PRF signal achieve an out-of-sample R-squared of 3.79% (5.34%) using a five-year (ten-year) minimum training period. Our analysis then demonstrates that this signal is particularly predictive during periods of economic downturn, when IVA-3PRF realization is low.
Low IVA-3PRF is correlated with a future deterioration in expected cash flows, which, in turn, suggests lower stock returns in the future. Additionally, we reject the hypothesis that the predictive power of IVA-3PRF is driven by private information embedded in the options prices by showing that the IVA signal does not work well when there is a divergence in market expectations: a scenario where private information would typically play a role.