Stock Returns, Implied Volatility Innovations, and the Asymmetric Volatility Phenomenon

We study the dynamic relation between daily stock returns and innovations in option-derived implied volatilities. By simultaneously analyzing innovations in index-level and firm-level implied volatilities, we distinguish between innovations in systematic and idiosyncratic volatility in an effort to better understand the asymmetric volatility phenomenon. Our results indicate that the relation between stock returns and innovations in systematic volatility (idiosyncratic volatility) is substantially negative (near zero). These results suggest that asymmetric volatility is primarily attributed to systematic influences (such as feedback of market-level volatility changes), rather than aggregated firm-level effects (such as leverage). We present new evidence that supports the assumption that innovations in implied volatility are good proxies for innovations in expected stock volatility. We also discuss our findings in relation to the implied volatility smile, the bias in implied volatility, return skewness, and hedging.