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Market Timing with Option-Implied Distributions: A Forward-Looking Approach

Management Science, Vol. 57, No. 7, pp. 1231-1249, 2011

Posted: 24 Nov 2011 Last revised: 27 Nov 2011

Alexandros Kostakis

University of Manchester - Manchester Business School

Nikolaos Panigirtzoglou

Queen Mary, University of London

George S. Skiadopoulos

University of Piraeus; Queen Mary, University of London, School of Economics and Finance

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Date Written: November 24, 2011

Abstract

We address the empirical implementation of the static asset allocation problem by developing a forward looking approach that uses information from market option prices. To this end, we extract constant maturity S&P 500 implied distributions and transform them to the corresponding risk-adjusted ones. Then, we form optimal portfolios consisting of a risky and a risk-free asset and evaluate their out-of-sample performance. We find that the use of risk-adjusted implied distributions times the market and makes the investor better off than if she uses historical returns’ distributions to calculate her optimal strategy. The results hold under a number of evaluation metrics and utility functions and carry through even when transaction costs are taken into account. Not surprisingly, the reported market timing ability deteriorated during the recent subprime crisis. An extension of the approach to a dynamic asset allocation setting is also presented.

Keywords: asset allocation, option-implied distributions, market timing, performance evaluation, portfolio

JEL Classification: C13, G10, G11, G13

Suggested Citation

Kostakis, Alexandros and Panigirtzoglou , Nikolaos and Skiadopoulos, George S., Market Timing with Option-Implied Distributions: A Forward-Looking Approach (November 24, 2011). Management Science, Vol. 57, No. 7, pp. 1231-1249, 2011. Available at SSRN: https://ssrn.com/abstract=1964203

Alexandros Kostakis

University of Manchester - Manchester Business School ( email )

Booth Street West
Manchester, M15 6PB
United Kingdom

Nikolaos Panigirtzoglou

Queen Mary, University of London ( email )

Mile End Road
London, London E1 4NS
United Kingdom

George Skiadopoulos (Contact Author)

University of Piraeus ( email )

80 Karaoli & Dimitriou Str.
18534 Piraeus, 185 34 -GR
Greece

HOME PAGE: http://web.xrh.unipi.gr/faculty/gskiadopoulos/

Queen Mary, University of London, School of Economics and Finance

Lincoln's Inn Fields
Mile End Rd.
London, E1 4NS
United Kingdom

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