Correlated Implied Volatility with Jump and Cross Section of Stock Returns

I derive the option‐implied volatility allowing for nonzero correlation between price jump and diffusive risk to examine the information content of implied diffusive, jump risks and their implied covariance in the cross‐sectional variation of future returns. This study documents a strong predictive power of realized volatility and correlated implied volatility spread (RV − IV) in the cross section of stock returns. The difference of realized volatility with the implied diffusive volatility (RV − σ), jump risk (RV − γ) and covariance (RV − ICov) can forecast future returns. These RV − σ and RV − γ anomalies are robustly persistent even after controlling for market, size, book‐to‐market value, momentum and liquidity factors.