Book Description
"I develop a new explanation of the implied volatility spread anomaly of Bali and Hovakimian (2009) and Cremers and Weinbaum (2010). The stock price observed in the stock market and the option implied stock price inferred from the option market are two noisy sources of information about the stock value. If these sources contain enough nonredundant information, the estimate of the stock value is between these prices, and the prices are expected to revert toward this estimate. This simple model is able to explain the reversals of the option implied prices toward the stock prices. Overall, the model of noisy prices is better aligned with the empirical patterns associated with the implied volatility spread phenomenon than other existing explanations of the phenomenon. I also document that if we invest in the implied volatility spread strategy at the end of each month, the next day excess return is 71 bps, which is almost twice as high as the average daily excess return of the implied volatility spread strategy. I show that this abnormal return from the end-of-month signal does not seem to be driven by seasonal trading patterns of institutional investors. If we take into account transaction costs, active trading on the implied volatility spread is too costly even for the marginal investor. This result is consistent with the model of noisy prices. However, the implied volatility spread can be used as a signal for the optimization of other trading strategies. If the implied volatility spread is used as a screening signal for a small stocks strategy, it modestly improves the performance of the baseline strategy"--Page vii.
