Volatility puzzles: a simple framework for gauging return-volatility regressions

This paper provides a simple theoretical framework for assessing the empirical linkages between returns and realized and implied volatilities. First, we show that whereas the volatility feedback effect as measured by the sign of the correlation between contemporaneous return and realized volatility depends importantly on the underlying structural model parameters, the correlation between return and implied volatility is unambiguously positive for all reasonable parameter configurations. Second, the asymmetric response of current volatility to lagged negative and positive returns, typically referred to as the leverage effect, is always stronger for implied than realized volatility. Third, implied volatilities generally provide downward biased forecasts Of Subsequent realized volatilities. Our results help explain previous findings reported in the extant empirical literature, and is further corroborated by new estimation results for a sample of monthly returns and implied and realized volatilities for the S&P500 aggregate market index. (c) 2005 Elsevier B.V. All rights reserved.