Option-Implied Equity Premia and the Predictability of Stock Market Returns

43 Pages Posted: 27 Sep 2011 Last revised: 20 Jan 2012

Date Written: January 19, 2012

Abstract

This paper proposes a novel approach to extracting option-implied equity premia, and empirically examines the information content of these risk premia for forecasting the stock market return. Our approach does not require specifying the functional form of the pricing kernel, and does not impose any restrictions on investors' preferences. We only assume the existence of put and call options which complete the market, and show that the equity premium can be inferred from expected excess returns on a portfolio of options. An empirical investigation of S&P 500 index options yields the following conclusions: (i) the implied equity premium predicts stock market returns; (ii) the implied equity premium consistently outperforms variables commonly used in the forecasting literature both in- and out-of-sample; (iii) at the cross-sectional level, stocks that are more sensitive to the implied equity premium have higher returns on average.

Keywords: implied risk premia, equity premium, predictability, cross-section, incomplete market, conditional CAPM

JEL Classification: G12, G13

Suggested Citation

Karoui, Mehdi, Option-Implied Equity Premia and the Predictability of Stock Market Returns (January 19, 2012). Available at SSRN: https://ssrn.com/abstract=1933617 or http://dx.doi.org/10.2139/ssrn.1933617

Mehdi Karoui (Contact Author)

OMERS ( email )

200 Bay Street, Suite 2300
Toronto, Ontario M5J2J2
Canada

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