Volatility Noise

Abstract

We investigate whether fitting errors of equity-option-implied volatility surfaces are informative about intermediary frictions. Relating observed implied volatilities to a smoothed volatility surface, we find that this error metric increases in idiosyncratic stock volatility and measures of option and stock illiquidity. An aggregation across the stock universe adds valuable information and the resulting overarching measure of volatility noise peaks during market distress, exhibits sensible correlations to economic state variables, and reveals a close link to intermediary equity and debt constraints. In line with intermediary asset pricing, we find that volatility noise is informative for the cross-sectional variation in expected returns beyond the equity option market.