Portfolio Optimization Using Forward-Looking Information

Forthcoming in: Review of Finance

36 Pages Posted: 29 Feb 2012 Last revised: 25 Jan 2014

See all articles by Alexander Kempf

Alexander Kempf

University of Cologne - Department of Finance & Centre for Financial Research (CFR)

Olaf Korn

Georg-August-Universität Göttingen

Sven Sassning

Georg-August-Universität Göttingen

Date Written: January 28, 2014

Abstract

In this paper we develop a new family of estimators of the covariance matrix that relies solely on forward-looking information. These estimators only use current price information from a cross-section of plain-vanilla options and employ different higher moments of the implied return distributions. In an out-of-sample study for US blue-chip stocks we show that a minimum-variance strategy based on these fully implied covariance estimators consistently outperforms a wide range of different benchmark strategies, including strategies based on historical estimates, index investing, and investing according to the 1/N rule. This result is very robust and holds with and without short-sales restrictions, with portfolios being rebalanced at different frequencies, and with transactions costs taken into account. The outperformance is particular strong in crisis periods when information flow and information asymmetry are high. The outperformance can only be reached using a fully implied approach; partially implied approaches that combine implied moments with historical ones might even perform worse than purely historical approaches. We further observe that covariance estimators based on implied second and fourth moments outperform estimators based on implied skewness. In conclusion, our results show that investors can better exploit possible diversification benefits by relying solely on forward-looking information from options markets.

Keywords: portfolio selection, option-implied information

JEL Classification: G11, G13, G17

Suggested Citation

Kempf, Alexander and Korn, Olaf and Sassning, Sven, Portfolio Optimization Using Forward-Looking Information (January 28, 2014). Forthcoming in: Review of Finance. Available at SSRN: https://ssrn.com/abstract=2012278 or http://dx.doi.org/10.2139/ssrn.2012278

Alexander Kempf

University of Cologne - Department of Finance & Centre for Financial Research (CFR) ( email )

Cologne, 50923
Germany
+49 221 470 2714 (Phone)
+49 221 470 3992 (Fax)

Olaf Korn (Contact Author)

Georg-August-Universität Göttingen ( email )

Platz der Göttinger Sieben 3
D-37073 Göttingen
Germany

Sven Sassning

Georg-August-Universität Göttingen ( email )

Platz der Göttinger Sieben 5
Göttingen, 37073
Germany

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