Option-Implied Equity Risk and the Cross-Section of Stock Returns
Posted: 28 Mar 2016 Last revised: 24 Apr 2021
Date Written: March 28, 2016
Using forward-looking information in the options market, we introduce a new method for better identifying systematic market risk as a predictor for the cross-section of stock returns. Empirical results show that there is a significantly positive relation between our option-implied beta and subsequent stock returns, in which a long-short portfolio formed on the option-implied beta generates an average monthly risk-adjusted return of 0.96%. In support of its economic significance, we further find that our option-implied beta significantly predicts the future realized betas and that the associated risk premium is a strong predictor of future market returns.
Keywords: Idiosyncratic skewness; option-implied beta; expected stock returns; equity risk; equity options
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