Forward-Looking Measures of Higher-Order Dependencies with an Application to Portfolio Selection

Abstract

This paper provides implied measures of higher-order dependencies between assets. The measures exploit only forward-looking information from the options market and can be used to construct an implied estimator of the covariance, co-skewness, and co-kurtosis matrices of asset returns. We show that higher-order dependencies vary heavily over time and identify the economic factors driving them. Furthermore, we run a portfolio selection exercise and show that investors can benefit from using the new estimator. They obtain a better risk-adjusted out-of-sample performance by up to 14% per year compared to when they use various historical and partially implied benchmark estimators.

Keywords: option-implied information, dependence measures, higher moments, portfolio selection

JEL Classification: G11, G13, G17