WHICH EXPLAINS AN EQUITY INDEX’S RETURN BETTER, THE CHANGE IN ITS OWN IMPLIED VOLATILITY OR THAT FOR A BROADER INDEX?

Susana Yu and Dean Leistikow

This study examines the proper risk proxy for an equity index. For each of nine indexes, an implied volatility index (VI) is computed from its options. For each, it determines whether the indexes’ return is explained better by the contemporaneous change in its own VI or that for a broader index. Overall, the broader indexes’ VI explains the indexes’ contemporaneous return better. We also find that the difference between the broader indexes’ VI and the individual indexes’ VI contributes to explaining the indexes’ contemporaneous return. Finally, we determine that the forward return differential between the indexes’ returns associated with high and low VI quintiles ranked by both the indexes’ VI and the broader indexes’ VI is positive. We also find that the differential is higher when ranked by the broader indexes’ VI.