Improving Portfolio Selection Using Option-Implied Volatility and Skewness
London Business School
Goethe University Frankfurt am Main
EDHEC Business School; Centre for Economic Policy Research (CEPR)
Goethe University Frankfurt - Department of Finance
CEPR Discussion Paper No. DP7686
Our objective in this paper is to examine whether one can use option-implied information to improve mean-variance portfolio selection with a large number of stocks, and to document which aspects of option-implied information are most useful for improving the out-of-sample performance of mean-variance portfolios. To calculate the optimal mean-variance portfolio weights, one needs to estimate for each stock its volatility, correlations with all other stocks, and expected return. Our empirical evidence shows that, while using the option-implied volatilities and correlations does not improve significantly the portfolio variance, Sharpe ratio, and certainty-equivalent return, exploiting information about expected returns that is contained in the volatility risk premium and option-implied skewness increases substantially Sharpe ratios and certainty-equivalent returns, but this is accompanied by higher portfolio turnover.
Number of Pages in PDF File: 49
Keywords: mean-variance, option-implied skewness, option-implied volatility, portfolio optimization, variance risk premium
JEL Classification: G11, G12, G13, G17working papers series
Date posted: March 1, 2010
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