The SKEW index: Extracting what has been left

Estimating real‐world probabilities: A forward‐looking behavioral framework

“…4. Though several researchers explore how to improve the forecasting ability of RNDs, the proposed adjustments are generally calibrated in-sample (see Alonso et al, 2009;Bliss & Panigirtzoglou, 2004;Kang et al, 2006;Liu et al, 2007). In contrast, our behavioral estimates are obtained strictly out-of-sample, respecting real-world conditions by using only the information known to investors at each forecast date.…”

“…A growing literature shows that option-implied distributions, even without risk-adjustments, outperform historical forecasts in information content. 2 Building on this insight, we examine whether the predictive ability of RNDs can be further improved by considering two attributes of real-world investors that manifest in asset prices: ▪ Risk preferences: Empirical papers show that when RNDs are adjusted to incorporate investor risk preferences, their explanatory power increases (see, among others, Bliss & Panigirtzoglou, 2004;DeMiguel et al, 2013;Høg & Tsiaras, 2011;Kostakis et al, 2011;Shackleton et al, 2010). ▪ Behavioral biases: Option prices reflect tailored views about specific areas of the return distribution, hence being prone to attract sentimental trades.…”

“…Following empirical evidence, we examine whether high skewness levels can be associated with biases in tail expectations (see Bevilacqua et al, 2018; Chen & Gan, 2018; Han, 2008). Specifically, we consider that sentiment biases are embodied in asset prices when exceeds a ± 1.5 threshold.…”

“…▪ Risk preferences: Empirical papers show that when RNDs are adjusted to incorporate investor risk preferences, their explanatory power increases (see, among others, Bliss & Panigirtzoglou, 2004;DeMiguel et al, 2013;Høg & Tsiaras, 2011;Kostakis et al, 2011;Shackleton et al, 2010). ▪ Behavioral biases: Option prices reflect tailored views about specific areas of the return distribution, hence being prone to attract sentimental trades.…”

Estimating Real World Probabilities: A Forward-Looking Behavioral Framework

“…Note that investor's perception of tail risk shifts over time and market participants may also underestimate left-tail risks. 14 See Han (2008), Chen and Gan (2018) and Bevilacqua et al (2018).…”