Using Equity, Index and Commodity Options to Obtain Forward-Looking Measures of Equity and Commodity Betas, and Idiosyncratic Variance

50 Pages Posted: 13 Oct 2020

See all articles by Ehud I. Ronn

Ehud I. Ronn

University of Texas at Austin - Department of Finance

Date Written: August 24, 2020

Abstract

This paper presents a parsimonious and theoretically-sound basis for extracting forward-looking measures of equity and commodity betas, and idiosyncratic variance.

Defining forward-looking betas and idiosyncratic variance as perturbations of historical estimates, we use the market prices of equity and index options under a single-factor market model to compute forward-looking term structures of equity betas and idiosyncratic variance. When applying the model to the market prices of options on oil company stocks and a market index, we are able to discern the market's perceptions regarding these oil companies' prospective beta, and hence signaling their future sensitivity to market changes. In turn, the prospective fraction of idiosyncratic variance relative to total variance provides a forward-looking market measure for onset of crises, when idiosyncratic risk fades relative to systematic, and complementing the information conveyed by VIX and the CBOE's equity implied correlation.

The model bears a natural extension to the joint use of options on equities and the futures price of oil. In so doing, we are able to discern a forward-looking oil beta. Such a beta, in conjunction with risk-neutral futures prices, gives rise to a CAPM-based forecast of oil prices.

Keywords: Implied volatilities, implied correlations and implied market betas

JEL Classification: G12; G13

Suggested Citation

Ronn, Ehud I., Using Equity, Index and Commodity Options to Obtain Forward-Looking Measures of Equity and Commodity Betas, and Idiosyncratic Variance (August 24, 2020). Available at SSRN: https://ssrn.com/abstract=3680156 or http://dx.doi.org/10.2139/ssrn.3680156

Ehud I. Ronn (Contact Author)

University of Texas at Austin - Department of Finance ( email )

Graduate School of Business
Austin, TX 78712
United States
512-471-5853 (Phone)
512-471-5073 (Fax)

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