Volatility information difference between CDS, options, and the cross section of options returns

Biao Guo, Yukun Shi and Yaofei Xu

Quantitative Finance, 2020, vol. 20, issue 12, 2025-2036

Abstract: We examine the difference in the information content in credit and options markets by extracting volatilities from corporate credit default swaps (CDSs) and equity options. The standardized difference in volatility, quantified as the volatility spread, is positively related to future option returns. We rank firms based on the volatility spread and analyze the returns for straddle portfolios buying both a put and a call option for the underlying firm with the same strike price and expiration date. A zero-cost trading strategy that is long (short) in the portfolio with the largest (smallest) spread generates a significant average monthly return, even after controlling for individual stock characteristics, traditional risk factors, and moderate transaction costs.

Date: 2020
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DOI: 10.1080/14697688.2020.1814018

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