| Existing studies document mixed evidence on Merton’s (1987) conjecture of a positive relation between conditional idiosyncratic stock variance and future stock returns. We revisit this issue using options-implied variance as a proxy for conditional variance because, as a forward-looking variable, options-implied variance has superior predictive power for future realized variance. In both cross-sectional (for individual stocks) and time-series (for the market index) regressions, we uncover a significantly negative relation between options-implied variance and future stock returns. Consistent with Miller’s (1977) divergence of opinion hypothesis, the negative relation is stronger (1) for stocks with more stringent short-sale constraints or (2) when shorting stocks becomes more difficult. |
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