The information content of option-implied information for volatility forecasting with investor sentiment

•Risk-neutral skewness has explanatory power only during high sentiment periods.•Forecasting power of implied volatility time-varies with investor sentiment.•Our findings are confirmed by both in-sample and out-of-sample analyses.•Forecasting power of historical information is not affected by investor sentiment.

This study explores the effect of investor sentiment on the volatility forecasting power of option-implied information. We find that the risk-neutral skewness has the explanatory power regarding future volatility only during high sentiment periods. Furthermore, the implied volatility has varying volatility forecasting ability depending on the level of investor sentiment. Our findings suggest that the effectiveness of volatility forecasting models based on option-implied information varies over time with the level of investor sentiment. We confirm the important role of investor sentiment in volatility forecasting models exploiting option-implied information with strong evidence from in-sample and out-of-sample analyses. We also present improvements in the accuracy of volatility forecasts from volatility forecasting models derived by incorporating investor sentiment in these models.