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

Volume 7, Number 3, Third Quarter 2009

This paper 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.