Implied Volatility Effect in Corporate Bonds
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Implied Volatility Changes and Corporate Bond Returns
Jie Cao; Amit Goyal; Xiao Xiao; Xintong Zhan
- HKHong Kong Polytechnic University
- ?The Hong Kong Polytechnic University - School of Accounting and Finance
- CHUniversity of Lausanne
- CHSwiss Finance Institute
- City, University of London
- ?City University London - Bayes Business School
- Fudan University
- ?Department of Finance, School of Management, Fudan University
Strategy in a nutshell
The investment universe consists of all US-listed corporate bonds with prices above $5 and maturities of at least 365 days. Excluded are structured notes, mortgage-backed, asset-backed, agency-backed, or equity-linked bonds; convertible and sinking-fund bonds; bonds with floating or irregular coupon frequencies; and intraday transactions labeled as when-issued, locked-in, or with special sales conditions exceeding two-day settlement.
First, calculate the one-month change in implied volatility from options (calls and puts) with a delta of 0.5 and 365-day maturity using the Cox-Ross-Rubinstein tree model, based on OptionMetrics data. The sorting variable is the average of call and put implied volatility changes. Bonds are then sorted into deciles based on this variable. The strategy goes long the lowest decile and short the highest decile. Portfolios are value-weighted and rebalanced monthly.
Economic rationale
Implied volatility from options appears to have predictive power for corporate bond returns for several reasons. Sophisticated investors active in the options market may anticipate market movements more effectively. Additionally, information may diffuse slowly from options to bond prices due to investor inattention. High limits to arbitrage may also prevent rapid price adjustment. Consequently, volatility is not fully reflected in bond prices, enabling the construction of a viable trading strategy around these signals.