Option-Implied Information and Predictability of Extreme Returns

SAFE Working Paper No. 5

40 Pages Posted: 1 Feb 2013

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: January 28, 2013

Abstract

We study whether prices of traded options contain information about future extreme market events. Our option-implied conditional expectation of market loss due to tail events, or tail loss measure, predicts future market returns, magnitude, and probability of the market crashes, beyond and above other option-implied variables. Stock-speci fic tail loss measure predicts individual expected returns and magnitude of realized stock-speci fic crashes in the cross-section of stocks. An investor that cares about the left tail of her wealth distribution benefi ts from using the tail loss measure as an information variable to construct managed portfolios of a risk-free asset and market index.

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 (January 28, 2013). SAFE Working Paper No. 5. Available at SSRN: https://ssrn.com/abstract=2209654 or http://dx.doi.org/10.2139/ssrn.2209654

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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