Dependence of option-return predictability on volatility-forecast accuracy

Determine how the cross-sectional predictability of individual equity option returns, driven by the realized-minus-implied volatility spread, depends on the out-of-sample accuracy of firm-level realized variance forecasts. Quantify this dependence using firm-level realized variance forecasts and evaluate whether improvements in volatility forecasting translate into stronger predictability of equity option returns.

Background

Prior literature documents that the spread between realized volatility and implied volatility predicts equity option returns, typically at monthly horizons. The paper investigates daily firm-level realized variance forecasts and their use in option portfolio construction. The authors acknowledge uncertainty about how much the quality of volatility forecasts influences the strength of option-return predictability based on the realized–implied spread.