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The Journal of Derivatives

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Sector Option Implied Volatility Dynamics and Predictability

Joseph M. Marks and David P. Simon
The Journal of Derivatives Winter 2017, 25 (2) 22-42; DOI: https://doi.org/10.3905/jod.2017.25.2.022
Joseph M. Marks
is an assistant professor of finance at Bentley University in Waltham, MA
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David P. Simon
is a professor of finance at Bentley University in Waltham, MA
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Abstract

As research is revealing more detail about the behavior of implied volatilities, the empirical evidence points to important differences between systematic volatility, that is correlated with the market index and is shared broadly across stocks, and idiosyncratic volatility that is largely independent of the rest of the market. It is the former that appears to command a significant variance risk premium in market prices. Marks and Simon examine an intermediate case: options on sector exchange traded funds. The underlying asset for an ETF is a portfolio of stocks within a single market sector. That is, the underlying is an index not a single stock, so volatility risk is somewhat systematic, but to the extent there is an important industry component to variance, it might behave more like single-stock idiosyncratic risk than like market risk. The results show a rich array of volatility effects, both in terms of different risk premia on different types of volatility, but also in terms of the speed of adjustment of sector IVs that appear to revert toward a relatively constant long term average relationship with systematic risk after deviating from it temporarily. Among other interesting results in the study: both market and sector IVs respond to realized returns, but sector “idiosyncratic” IVs are more symmetrical in responding to positive and negative returns; however, the impact of a negative return appears immediately, while sector IVs respond more slowly to positive returns. Overall, the article provides new evidence showing the rich structure of implied volatility dynamics.

TOPICS: Options, exchange-traded funds and applications, analysis of individual factors/risk premia, quantitative methods

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The Journal of Derivatives: 25 (2)
The Journal of Derivatives
Vol. 25, Issue 2
Winter 2017
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Sector Option Implied Volatility Dynamics and Predictability
Joseph M. Marks, David P. Simon
The Journal of Derivatives Nov 2017, 25 (2) 22-42; DOI: 10.3905/jod.2017.25.2.022

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Sector Option Implied Volatility Dynamics and Predictability
Joseph M. Marks, David P. Simon
The Journal of Derivatives Nov 2017, 25 (2) 22-42; DOI: 10.3905/jod.2017.25.2.022
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  • Article
    • Abstract
    • BACKGROUND AND DATA SUMMARY
    • LONG-RUN BEHAVIOR AND IMPLIED VOLATILITY DYNAMICS
    • SECTOR VOLATILITY PREMIUMS AND SECTOR IMPLIED VOLATILITY CHANGES
    • IDIOSYNCRATIC VOLATILITY PREMIUMS AND SECTOR IMPLIED VOLATILITY CHANGES
    • THE REACTION OF SECTOR IMPLIED VOLATILITIES TO SECTOR RETURNS
    • THE REACTION OF SECTOR IMPLIED VOLATILITIES TO POSITIVE AND NEGATIVE CONTEMPORANEOUS AND LAGGED RETURNS
    • THE REACTION OF SECTOR IMPLIED VOLATILITIES TO SYSTEMATIC AND IDIOSYNCRATIC CONTEMPORANEOUS RETURNS
    • THE RESPONSE OF IMPLIED VOLATILITY TO CONTEMPORANEOUS AND LAGGED SYSTEMATIC AND IDIOSYNCRATIC RETURNS
    • PREDICTIVE MODELS OF SECTOR IMPLIED VOLATILITY CHANGES AND THE USEFULNESS OF THESE MODELS FOR PREDICTING OUT-OF-SAMPLE DELTA-HEDGED RETURNS
    • THE MODELS
    • THE MODEL ESTIMATES
    • OUT-OF-SAMPLE PREDICTED IMPLIED VOLATILITY CHANGES AND THE PROFITABILITY OF DELTA-HEDGED SECTOR CALL POSITIONS
    • CONCLUSIONS
    • ENDNOTES
    • REFERENCES
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