We study the cross-section of stock option returns by sorting stocks on the difference between historical realized volatility and at-the-money implied volatility. We find that a zero-cost trading strategy that is long (short) in the portfolio with a large positive (negative) difference between these two volatility measures produces an economically and statistically significant average monthly return. The results are robust to different market conditions, to stock risks-characteristics, to various industry groupings, to option liquidity characteristics, and are not explained by usual risk factor models.

The market for auction rate securities (ARS) made headlines during the second week of February 2008 when auctions at which the bonds’ interest rates reset experienced a wave of “failures.” Contrary to headlines that attribute the failures to a “frozen” market or investors’ “irrationality,” we find that (1) even at their height, less than 50% of ARS experienced auction failures, (2) the likelihood of auction failure was directly related to the level of the bonds’ “maximum auction rates,” (3) the implied market clearing yields of bonds with failed auctions were significantly above their maximum auction rates, and (4) ARS yields were generally higher than yields of various cash equivalent investment alternatives. We infer that investors priced the possibility of auctions failures into ARS yields and rationally declined to bid for bonds for which required market yields exceeded their maximum auction rates.