Abstract

This study examines the relationship between volatility and the probability of occurrence of expected extreme returns in the Canadian market. Three measures of volatility are examined: implied volatility from firm option prices, conditional volatility calculated using an EGARCH model and idiosyncratic volatility based on the Fama and French five-factor model. A significantly positive relationship is observed between a firm’s idiosyncratic volatility and the probability of occurrence of an extreme return in the subsequent month for firms. A 10% increase in idiosyncratic volatility in a given month is associated with the probability of an extreme shock in the subsequent month (top or bottom 1.5% of the returns distribution) of 26.4%. Other firm characteristics, including firm age, price, volume and Book-to-Market ratio, are also shown to be significantly related to subsequent firm extreme returns. The effects of conditional and implied volatility are mixed.

Keywords: Extreme return; Implied volatility; Conditional volatility; Idiosyncratic volatility; Five-Factor model; Probit regression;
JEL Codes: G10, G11, G14, G17