Relative Option Prices and Risk-Neutral Skew as Predictors of Index Returns

Ratcliff, Ryan

doi:10.3905/jod.2013.21.2.089

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Option Prices and The Real World1

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“…Implied volatility has also been demonstrated to be an upward biased predictor of future realized volatility, see e.g., Canina and Figlewski (1993). More recently, research has focused on the predictive information content of the implied volatility skew, e.g., Xing, Zhang, and Zhao (2010) and Ratcli (2013). Higher order moments of the risk-neutral distribution, based on the results in Bakshi, Kapadia, and Madan (2003), have been investigated in Rehman and Vilkov (2012) and Conrad, Dittmar, and Ghysels (2013).…”

Section: Option Prices and The Real Worldmentioning

confidence: 99%

An Empirical Analysis of the Ross Recovery Theorem

2014

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Building on the results of Ludwig (2012), we propose a method to construct robust timehomogeneous Markov chains that capture the risk-neutral transition of state prices from current snapshots of option prices on the S&P 500 index. Using the recovery theorem of Ross (2013), we then derive the market's forecast of the real-world return density and investigate the predictive information content of its moments. We find that changes in the recovered moments can be used to time the index, yielding strategies that not only outperform the market, but are also significantly less volatile.

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