Option-Implied Equity Premium Predictions via Entropic Tilting

35 Pages Posted: 26 Mar 2016 Last revised: 12 Sep 2017

See all articles by Konstantinos Metaxoglou

Konstantinos Metaxoglou

Carleton University

Davide Pettenuzzo

Brandeis University - Department of Economics

Aaron Smith

University of California, Davis - Department of Agricultural and Resource Economics

Date Written: September 9, 2017

Abstract

We propose a new method to improve density forecasts of the equity premium using information from options markets. We obtain predictive densities from stochastic volatility (SV) and GARCH models, which we then tilt using the second moment of the risk-neutral distribution implied by options prices while imposing a non-negativity constraint on the equity premium. By combining the backward-looking information contained in the GARCH and SV models with the forward-looking information from options prices, our procedure improves the performance of predictive densities. Using density forecasts of the U.S. equity premium from January 1990 to December 2014, we find that tilting leads to more accurate predictions using statistical and economic criteria.

Keywords: entropic tilting, density forecasts, variance risk premium, equity premium, options

JEL Classification: C11, C22, G11, G12

Suggested Citation

Metaxoglou, Konstantinos and Pettenuzzo, Davide and Smith, Aaron D., Option-Implied Equity Premium Predictions via Entropic Tilting (September 9, 2017). Available at SSRN: https://ssrn.com/abstract=2754246 or http://dx.doi.org/10.2139/ssrn.2754246

Konstantinos Metaxoglou

Carleton University ( email )

Davide Pettenuzzo (Contact Author)

Brandeis University - Department of Economics ( email )

Waltham, MA 02454-9110
United States
781.736.2834 (Phone)
781.736.2269 (Fax)

Aaron D. Smith

University of California, Davis - Department of Agricultural and Resource Economics ( email )

One Shields Avenue
Davis, CA 95616
United States
530-752-2138 (Phone)
530-752-5614 (Fax)

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