Generalized Bounds on the Conditional Expected Excess Return on Individual Stocks

Abstract

We derive generalized bounds on conditional expected excess returns that can be computed from option prices. The generalized lower bound (GLB) may serve as an expected excess return proxy for individual and basket-type assets, is conditionally tight, accounts for the entire risk-neutral distribution of returns, and outperforms existing variance-based models in out-of-sample predictions. Bounds calibrated to realized returns correspond to reasonable risk aversion and prudence. On average, expected stock returns given by the bounds decrease on even weeks of the FOMC cycle. Cross-sectional tests deliver a reasonable market risk premium.

Keywords: Recovery, market spanning, expected returns, higher-order moments, option-implied, FOMC cycle

JEL Classification: G11, G12, G13, G17