An Examination of Ex Ante Risk and Return in the Cross-Section Using Option-Implied Information
Forthcoming, European Journal of Finance.
44 Pages Posted: 24 Jun 2020 Last revised: 7 Jan 2021
Date Written: April 1, 2020
This paper examines cross-sectional relations between ex ante expected returns and betas. As a proxy for ex ante expected returns, we use implied returns obtained from the risk-adjusted option pricing model suggested in this paper. We find that implied returns have a positive and significant cross-sectional relation with implied betas in all maturity groups considered. This significant relation is maintained regardless of the inclusion of the well-known CAPM-anomaly variables such as firm size, book-to-market, past returns, earnings-to-price ratio, and liquidity. Ex ante market risk premium estimates have a statistical significance as well as an economic significance in that they contain significant forward-looking information on future macroeconomic conditions. Thus, market betas are priced on an ex ante basis.
Keywords: Option-implied return, Option-implied beta, Risk-adjusted option pricing model, Cross-section of expected returns, Macroeconomic condition
JEL Classification: G12, G13, G14
Suggested Citation: Suggested Citation