Using options-implied variance, a forward-looking measure of conditional variance, we revisit the debate on the idiosyncratic risk-return relation. In both cross-sectional (for individual stocks) and time-series (for the market index) regressions, we find a negative relation between options-implied variance and future stock returns. Consistent with Miller's (1977) divergence of opinion hypothesis, the negative relation gets stronger (1) for stocks with more stringent short-sale constraints or (2) when shorting stocks becomes more difficult. Moreover, the negative correlation of realized idiosyncratic variance or analyst forecast dispersion with future stock returns mainly reflects their close correlation with our conditional idiosyncratic variance measure.

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Journal of Banking & Finance
Erasmus Research Institute of Management

Guo, H, & Qiu, B. (2014). Options-implied variance and future stock returns. Journal of Banking & Finance, 44(1), 93–113. doi:10.1016/j.jbankfin.2014.04.002