Kostakis, A., Panigirtzoglou, Nikolaos and Skiadopoulos, Georgios. (2011) Market timing with option-implied distributions : a forward-looking approach. Management Science, Vol.57 (No.7). pp. 1231-1249. ISSN 0025-1909

Full text not available from this repository.

Abstract

We address the empirical implementation of the static asset allocation problem by developing a forward-looking approach that uses information from market option prices. To this end, we extract constant maturity S&P 500 implied distributions and transform them to the corresponding risk-adjusted ones. Then we form optimal portfolios consisting of a risky and a risk-free asset and evaluate their out-of-sample performance. We find that the use of risk-adjusted implied distributions times the market and makes the investor better off than if 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 the approach to a dynamic asset allocation setting is also presented.

Item Type:	Journal Article
Subjects:	H Social Sciences > HG Finance
Divisions:	Faculty of Social Sciences > Warwick Business School
Library of Congress Subject Headings (LCSH):	Asset allocation, Options (Finance), Stock price forecasting, Stock price indexes, Speculation, Investment analysis
Journal or Publication Title:	Management Science
Publisher:	Institute for Operations Research and the Management Sciences (I N F O R M S)
ISSN:	0025-1909
Date:	July 2011
Volume:	Vol.57
Number:	No.7
Page Range:	pp. 1231-1249
Identification Number:	10.1287/mnsc.1110.1346
Status:	Peer Reviewed
Publication Status:	Published
Funder:	University of Piraeus, Fundação para a Ciência e a Tecnologia (FCT)
Grant number:	PTDC/EGE-ECO/099255/2008 (FCT)
References:	Adler, T., M. Kritzman. 2007. Mean-variance versus full-scale optimization: In and out of sample. J. Asset Management 7(5) 302–311. Aït-Sahalia, Y., M. W. Brandt. 2008. Consumption and portfolio choice with option-implied state prices, NBER Working Paper 13854, National Bureau of Economic Research, Cambridge, MA. Aït-Sahalia, Y., A. W. Lo. 2000. Nonparametric risk management and implied risk aversion. J. Econometrics 94(1–2) 9–51. Alentorn, A., S. Markose. 2008. Generalized extreme value distribution and extreme economic value at risk (EE-VaR). E. J. Kontoghiorghes, B. Rustem, P. Winker, eds. Computational Methods in Financial Engineering: Essays in Honor of Manfred Gilli. Springer-Verlag, Berlin, 47–71. Anagnou-Basioudis, I., M. Bedendo, S. D. Hodges, R. Tompkins. 2005. Forecasting accuracy of implied and GARCH-based probability density functions. Rev. Futures Markets 14(1) 41–66. Ang, A., G. Bekaert, J. Liu. 2005. Why stocks may disappoint. J. Financial Econom. 76(3) 471–508. Bakshi, G., G. Panayotov, G. Skoulakis. 2011. Improving the predictability of real economic activity and asset returns with forward variances inferred from option portfolios. J. Financial Econom. 100(3) 475–495. Barberis, N., M. Huang, T. Santos. 2001. Prospect theory and asset prices. Quart. J. Econom. 116(1) 1–53. Barone-Adesi, G., R. E. Whaley. 1987. Efficient analytical approximation of American option values. J. Finance 42(2) 301–320. Bates, D. S. 1991. The crash of ’87: Was it expected? The evidence from options markets. J. Finance 46(3) 1009–1044. Berkowitz, J. 2001. Testing density forecasts with applications to risk management. J. Bus. Econom. Statist. 19(4) 465–474. Black, F. 1976. The pricing of commodity contracts. J. Financial Econom. 3(1–2) 167–179. Bliss, R. R., N. Panigirtzoglou. 2002. Testing the stability of implied probability density functions. J. Banking Finance 26(2) 381–422. Bliss, R. R., N. Panigirtzoglou. 2004. Option-implied risk aversion estimates. J. Finance 59(1) 407–446. Bollerslev, T. 1987. A conditionally heteroskedastic time series model for security prices and rates of return data. Rev. Econom. Statist. 69(3) 542–547. Breeden, D. T., R. H. Litzenberger. 1978. Prices of state-contingent claims implicit in option prices. J. Bus. 51(4) 621–651. Brunnermeier, M. 2009. Deciphering the liquidity and credit crunch 2007–2008. J. Econom. Perspect. 23(1) 77–100. Campbell, J. Y., L. M. Viceira. 1999. Consumption and portfolio decisions when expected returns are time-varying. Quart. J. Econom. 114(2) 433–495. Campbell, J. Y., L. M. Viceira. 2001. Who should buy long-term bonds? Amer. Econom. Rev. 91(1) 99–127. Campbell, J. Y., G. Chacko, J. Rodriguez, L. M. Viceira. 2004. Strategic asset allocation in a continuous-time VAR model. J. Econom. Dynam. Control 28(11) 2195–2214. Carr, P., L. Wu. 2009. Variance risk premiums. Rev. Financial Stud. 22(3) 1311–1341. Chacko, G., L. M. Viceira. 2005. Dynamic consumption and portfolio choice under stochastic volatility and incomplete markets. Rev. Financial Stud. 18(4) 1369–1402. Chan, L. K. C., J. Karceski, J. Lakonishok. 1999. On portfolio optimization: Forecasting covariances and choosing the risk model. Rev. Financial Stud. 12(5) 937–974. Chang, B.-Y., P. Christoffersen, K. Jacobs, G. Vainberg. 2009. Optionimplied measures of equity risk. Working paper, McGill University, Montreal, QC. Chopra, V. K, W. T. Ziemba. 1993. The effect of errors in means, variances and covariances on optimal portfolio choice. J. Portfolio Management 19(2) 6–11. Cox, J. C., C.-F. Huang. 1989. Optimal consumption and portfolio policies when asset prices follow a diffusion process. J. Econom. Theory 49(1) 33–83. Cremers, M., D. Weinbaum. 2010. Deviations from put-call parity and stock return predictability. J. Financial Quant. Anal. 45(2) 335–367. DeMiguel, V., L. Garlappi, R. Uppal. 2009. How inefficient are simple asset allocation strategies? Rev. Financial Stud. 22(5) 1915–1953. DeMiguel, V., Y. Plyakha, R. Uppal, G. Vilkov. 2011. Improving portfolio selection using option-implied volatility and skewness. Working paper, Goethe University, Frankfurt am Main, Germany. Driessen, J., P. J. Maenhout. 2007. An empirical portfolio perspective on option pricing anomalies. Rev. Finance 11(4) 561–603. Driessen, J., P. J. Maenhout, G. Vilkov. 2009. The price of correlation risk: Evidence from equity options. J. Finance 64(3) 1377–1406. Duan, J.-C., W. Zhang. 2010. Forward-looking market risk premium, Working paper, National University of Singapore, Singapore. Engle, R. F., D. M. Lilien, R. P. Robins. 1987. Estimating time varying risk premia in the term structure: The ARCH-M model. Econometrica 55(2) 391–407. Fabozzi, F. J., S. M. Focardi, C. Jonas. 2010. Investment Management After the Global Financial Crisis. Research Foundation of CFA Institute, Charlottesville, VA. Fleming, J., C. Kirby, B. Ostdiek. 2001. The economic value of volatility timing. J. Finance 56(1) 329–352. Garlappi, L., G. Skoulakis. 2009. Taylor series approximations to expected utility and optimal portfolio choice, Working paper, University of British Columbia, Vancouver, BC. Gemmill, G., A. Saflekos. 2000. How useful are implied distributions? Evidence from stock-index options. J. Derivatives 7(3) 83–98. Giamouridis, D., G. Skiadopoulos. 2011. The informational content of financial options for quantitative asset management: A review. B. Scherer, K. Winston, eds. Handbook of Quantitative Asset Management. Oxford University Press, Oxford, UK, Forthcoming. Golez, B. 2010. Expected returns and dividend growth rates implied in derivative markets. Working paper, Pompeu Fabra University, Barcelona, Spain. Guidolin, M., A. Timmermann. 2008. International asset allocation under regime switching, skew and kurtosis preferences. Rev. Financial Stud. 21(2) 889–935. Gul, F. 1991. A theory of disappointment aversion. Econometrica 59(3) 667–686. Israelsen, C. L. 2005. A refinement to the sharpe ratio and information ratio. J. Asset Management 5(6) 423–427. Jabbour, C., J. F. Peˇ na, J. C. Vera, L. F. Zuluaga. 2008. An estimationfree, robust CVaR portfolio allocation model. J. Risk 11(1) 57–78. Jackwerth, J. 2004. Option-Implied Risk-Neutral Distributions and Risk Aversion. Research Foundation of CFA Institute, Charlottesville, VA. Jiang, G., Y. Tian. 2005. The model-free implied volatility and its information content. Rev. Financial Stud. 18(4) 1305–1342. Jondeau, E., M. Rockinger. 2003. Conditional volatility, skewness, and kurtosis: Existence, persistence, and comovements. J. Econom. Dynam. Control 27(10) 1699–1737. Jondeau, E., M. Rockinger. 2006. Optimal portfolio allocation under higher moments. Eur. Financial Management 12(1) 29–55. Jondeau, E., M. Rockinger. 2008. The economic value of distributional timing, Working paper, University of Lausanne, Lausanne, Switzerland. Jones, R. C. 2010. Maybe it really is different this time. J. Portfolio Management 36(2) 60–72. Kan, R., G. Zhou. 2007. Optimal portfolio choice with parameter uncertainty. J. Financial Quant. Anal. 42(3) 621–656. Kang, B. J., T. S. Kim. 2006. Option-implied risk preferences: An extension to wider classes of utility functions. J. Financial Markets 9(2) 180–198. Kroll, Y., H. Levy, H. M. Markowitz. 1984. Mean-variance versus direct utility maximization. J. Finance 36(1) 47–61. Liu, X., M. B. Shackleton, S. J. Taylor, X. Xu. 2007. Closed-form transformations from risk-neutral to real-world distributions. J. Banking Finance 31(5) 1501–1520. Merton, R. C. 1973. A rational theory of option pricing. Bell J. Econom. Management Sci. 41(1) 141–183. Merton, R. C. 1980. On estimating the expected return on the market: An exploratory investigation. J. Financial Econom. 8(4) 323–361. Nelson, D. B. 1991. Conditional heteroskedasticity in asset returns: A new approach. Econometrica 59(2) 347–370. Panigirtzoglou, N., G. Skiadopoulos. 2004. A new approach to modeling the dynamics of implied distributions: Theory and evidence from the S&P 500 options. J. Banking Finance 28(7) 1499–1520. Poon, S.-H., C. W. J. Granger. 2003. Forecasting volatility in financial markets: A review. J. Econom. Literature 41(2) 478–539. Sharpe, W. F. 2007. Expected utility asset allocation. Financial Analysts J. 63(5) 18–30. Siegel, A. F. 1995. Measuring systematic risk using implicit beta. Management Sci. 41(1) 124–128. Siegel, A. F., A. Woodgate. 2007. Performance of portfolios optimized with estimation error. Management Sci. 53(6) 1005–1015. Simaan, Y. 1993. What is the opportunity cost of mean-variance investment strategies? Management Sci. 39(5) 578–587. Söderlind, P., L. E. O. Svensson. 1997. New techniques to extract market expectations from financial instruments. J. Monetary Econom. 40(2) 383–429. Veld, C., Y. V. Veld-Merkoulova. 2008. The risk perceptions of individual investors. J. Econom. Psych. 29(2) 226–252. Wachter, J. A. 2002. Portfolio and consumption decisions under mean-reverting returns: An exact solution for complete markets. J. Financial Quant. Anal. 37(1) 63–91. Xing, Y., X. Zhang, R. Zhao. 2010. What does individual option volatility smirk tell us about future equity returns? J. Financial Quant. Anal. 45(3) 641–662.
URI:	http://wrap.warwick.ac.uk/id/eprint/38797

Data sourced from Thomson Reuters' Web of Knowledge

Request changes to a record

Actions (login required)

View Item