Forward-Looking Measures of Higher-Order Dependencies with an Application to Portfolio Selection
35 Pages Posted: 27 Jan 2014 Last revised: 19 May 2016
Date Written: December 31, 2015
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
Suggested Citation: Suggested Citation