Market Returns Dormant in Option Panels

Abstract

This paper develops a novel functional predictive regression framework linking optionimplied distributions to stock market returns, motivated by the fundamental link between risk-neutral and physical densities. Using S&P 500 option panels, our model exhibits significant forecasting power, achieving robust out-of-sample R2 exceeding 4% for monthly return predictions, outperforming traditional predictors. Superior performance arises from leveraging the full spectrum of the risk-neutral density via functional principal components. Our analysis reveals that forecasting success stems from nuanced variations in risk-neutral densities, reflecting various economic states of risk perception and trading frictions, and demonstrates potential economic gains through a markettiming strategy.

Keywords: JEL classification codes: G12, G17 functional predictive regression, market risk premium, option market, return predictability, risk-neutral measure, stochastic discount factor