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Portfolio Optimization Using ForwardLooking Information 1 by
"... Information In this paper we develop the first estimator of the covariance matrix that relies solely on forwardlooking information. This estimator only uses price information from a crosssection of plainvanilla options. In an outofsample study for US bluechip stocks we show that a minimumvari ..."
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Information In this paper we develop the first estimator of the covariance matrix that relies solely on forwardlooking information. This estimator only uses price information from a crosssection of plainvanilla options. In an outofsample study for US bluechip stocks we show that a minimumvariance strategy based on this fully implied estimator consistently outperforms a wide range of benchmark strategies, including strategies based on historical estimates, index investing, and investing according to the 1/N rule. The outperformance is strong in periods of high information asymmetry, whereas in quiet periods all strategies lead to similar results. The outperformance can only be reached using a fully implied approach; partially implied approaches that combine implied moments with historical ones might even perform worse than purely historical approaches. Selecting an optimal portfolio is a classical problem in finance. Although the solution for the meanvariance investor is well known since the seminal work by Markowitz (1952), implementation
Market Timing with OptionImplied Distributions: A ForwardLooking Approach*
, 2008
"... We address the empirical implementation of the static asset allocation problem by developing a forwardlooking approach that uses information from market option prices. To this end, constant maturity S&P 500 implied distributions are extracted and subsequently transformed to the corresponding ri ..."
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We address the empirical implementation of the static asset allocation problem by developing a forwardlooking approach that uses information from market option prices. To this end, constant maturity S&P 500 implied distributions are extracted and subsequently transformed to the corresponding riskadjusted ones. Then, we form optimal portfolios consisting of a risky and a riskfree asset and evaluate their outofsample performance. We find that the use of riskadjusted implied distributions times the market and makes the investor better off compared with the case where she uses historical returns ’ distributions to calculate her optimal strategy. The results hold under a number of evaluation metrics and utility functions and carry through even when transaction costs are taken into account. Not surprisingly, the reported market timing ability deteriorated during the recent subprime crisis. An extension of
referees for their constructive, stimulating and thorough comments. We would also like to thank Carol
, 2008
"... We address the empirical implementation of the static asset allocation problem by developing a forwardlooking approach that uses information from market option prices. To this end, constant maturity S&P 500 implied distributions are extracted and subsequently transformed to the corresponding ri ..."
Abstract
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We address the empirical implementation of the static asset allocation problem by developing a forwardlooking approach that uses information from market option prices. To this end, constant maturity S&P 500 implied distributions are extracted and subsequently transformed to the corresponding riskadjusted ones. Then, we form optimal portfolios consisting of a risky and a riskfree asset and evaluate their outofsample performance. We find that the use of riskadjusted implied distributions times the market and makes the investor better off compared with the case where she uses historical returns ’ distributions to calculate her optimal strategy. The results hold under a number of evaluation metrics and utility functions and carry through even when transaction costs are taken into account. Not surprisingly, the reported market timing ability deteriorated during the recent subprime
Uncertainty and Leveraged Lucas Trees: The Cross Section of Equilibrium Volatility Risk
"... Volatility risk premia compensate agents for holding assets whose payoffs correlate with times of high return variation. This paper takes a structural approach to explain the crosssection of volatility risk premia of stocks using a Lucas orchard with heterogeneous beliefs, stochastic macroeconomic ..."
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Volatility risk premia compensate agents for holding assets whose payoffs correlate with times of high return variation. This paper takes a structural approach to explain the crosssection of volatility risk premia of stocks using a Lucas orchard with heterogeneous beliefs, stochastic macroeconomic uncertainty, and default risk. I study two manifestations of uncertainty, namely (i) agents ’ disagreement and (ii) timevarying volatility of fundamental growth rates. The paper shows that while the former source of risk accounts for the level of the risk premia, the latter mainly affects the higher order moments of the risk premium distribution. Together with uncertainty, default risk associated with levered trees implies a nonmonotonic equilibrium link between stock returns and volatility which allows for positive or negative risk premia. Calibrating the economy, I show that the model accounts for predictability of excess stock returns and corporate credit spreads. I construct volatility risk premia from option and stock prices and document that in the timeseries, volatility risk premia of individual stocks can be positive or negative, and switch sign rather often. In the crosssection, they are only weakly related to traditional risk factors. I then test the model predictions and find that empirical proxies for investors’ uncertainty about expected growth rates and macroeconomic uncertainty are priced risk factors that convey information over and above those contained in other standard factors to explain these risk premia. In line with the model predictions, I present predictability evidence of individual volatility risk premia for stock excess returns and corporate credit spreads.
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"... We address the empirical implementation of the static asset allocation problem by developing a forwardlooking approach that uses information from market option prices. To this end, constant maturity S&P 500 implied distributions are extracted and subsequently transformed to the corresponding ri ..."
Abstract
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We address the empirical implementation of the static asset allocation problem by developing a forwardlooking approach that uses information from market option prices. To this end, constant maturity S&P 500 implied distributions are extracted and subsequently transformed to the corresponding riskadjusted ones. Then, optimal portfolios consisting of a risky and a riskfree asset are formed and their outofsample performance is evaluated. We find that the use of riskadjusted implied distributions makes the investor significantly better off compared with the case where she uses the historical distribution of returns to calculate her optimal strategy. The results hold under a number of evaluation metrics and utility functions and carry through even when transaction costs are taken into account. An extension of the
Asset Allocation with OptionImplied Distributions: A ForwardLooking Approach *
, 2008
"... We address the empirical implementation of the static asset allocation problem by developing a forwardlooking approach that uses information from market option prices. To this end, constant maturity S&P 500 implied distributions are extracted and subsequently transformed to the corresponding ri ..."
Abstract
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We address the empirical implementation of the static asset allocation problem by developing a forwardlooking approach that uses information from market option prices. To this end, constant maturity S&P 500 implied distributions are extracted and subsequently transformed to the corresponding riskadjusted ones. Then, optimal portfolios consisting of a risky and a riskfree asset are formed and their outofsample performance is evaluated. We find that the use of riskadjusted implied distributions makes the investor significantly better off compared with the case where she uses the historical distribution of returns to calculate her optimal strategy. The results hold under a number of evaluation metrics and utility functions and carry through even when transaction costs are taken into account. An extension of the approach to a dynamic asset allocation setting is also presented.
Does Information Content of Option Prices Add Value for Asset Allocation?
"... Abstract. The aim of this paper is to determine whether forwardlooking option implied returns forecasts lead to better outofsample portfolio performance than conventional time series models. We consider a simple twoasset setting with a riskfree asset and the S&P 500 index the risky asset w ..."
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Abstract. The aim of this paper is to determine whether forwardlooking option implied returns forecasts lead to better outofsample portfolio performance than conventional time series models. We consider a simple twoasset setting with a riskfree asset and the S&P 500 index the risky asset with monthly allocation revisions. We carry out a comprehensive analysis with a wide range of timeseries models, two riskneutral density inference methods, two utility functions, and several performance metrics. Portfolios are compared over the period of January 1994 to April 2010. Our main contribution is to compare the merits of implied volatility smoothing and maximum entropy riskneutral density estimation techniques. By using bid/ask quotes in place of the closing prices, we obtain smooth probability densities using the maximum entropy principle that outperform the probability densities obtained using the implied volatility smoothing method. We also identify which moments of the optionimplied probability densities contribute most to portfolio performance.
SFB
, 2013
"... A completely automated optimization strategy for global minimumvariance portfolios based on a new test for structural breaks D iscussion P aper ..."
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A completely automated optimization strategy for global minimumvariance portfolios based on a new test for structural breaks D iscussion P aper
1 The Informational Content of Financial Options for Quantitative Asset Management: A Review
"... The view that informed investors might choose to trade derivatives has been shared by both academics and practitioners from as early as the introduction of options trading in the early 1970s. Black (1975) claims that “...Since an investor can get more action for a given investment in options than he ..."
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The view that informed investors might choose to trade derivatives has been shared by both academics and practitioners from as early as the introduction of options trading in the early 1970s. Black (1975) claims that “...Since an investor can get more action for a given investment in options than he can by investing directly in the underlying stock, he may choose