Option-Implied Information and Predictability of Extreme Returns

37 Pages Posted: 16 Sep 2012 Last revised: 25 Sep 2012

See all articles by Grigory Vilkov

Grigory Vilkov

Frankfurt School of Finance & Management

Yan Xiao

Goethe University Frankfurt

Multiple version iconThere are 2 versions of this paper

Date Written: September 24, 2012

Abstract

We study whether option-implied conditional expectation of market loss due to tail events, or tail loss measure, contains information about future returns, especially the negative ones. Our tail loss measure predicts future market returns, magnitude, and probability of the market crashes, beyond and above other option-implied variables. Stock-specific tail loss measure predicts individual expected returns and magnitude of realized stock-specific crashes in the cross-section of stocks. An investor, especially the one who cares about the left tail of her wealth distribution (e.g., disappointment-averse), benefits from using the tail loss measure as an information variable to construct managed portfolios of a risk-free asset and market index. The tail loss measure is motivated by the results of the extreme value theory, and it is computed from observed prices of out-of-the-money put as the risk-neutral expected value of a loss beyond a given relative threshold.

Keywords: extreme value theory, tail measure, implied correlation, variance risk premium, option-implied distribution, predictability, portfolio optimization

JEL Classification: G11, G12, G13, G17

Suggested Citation

Vilkov, Grigory and Xiao, Yan, Option-Implied Information and Predictability of Extreme Returns (September 24, 2012). Available at SSRN: https://ssrn.com/abstract=2147437 or http://dx.doi.org/10.2139/ssrn.2147437

Grigory Vilkov (Contact Author)

Frankfurt School of Finance & Management ( email )

Adickesallee 32-34
Frankfurt am Main, 60322
Germany

HOME PAGE: http://www.vilkov.net

Yan Xiao

Goethe University Frankfurt ( email )

Gr├╝neburgplatz 1
Frankfurt am Main, DE 60323
Germany

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