The Ex Ante Physical Distributions of Individual Stock Returns
55 Pages Posted: 2 Dec 2020 Last revised: 16 Feb 2021
Date Written: September 17, 2020
I present a method for deriving the entire physical return distributions of individual stocks directly from option prices. The method is theoretically nested in an equilibrium model, obeys the law-of one-price, and can be implemented in real-time in a forward-looking manner. The method performs well out-of-sample in predicting ex-post distributions of individual stock returns. The physical stock distributions and the co-moments with the market are important for risk-management decisions, portfolio allocation, and can help understand the cross-section of returns. A tradeable long-short portfolio that buys (sells) low (high) co-skewness stocks yields a monthly five-factor alpha of 0.61% (t-stat 3.25). The equity risk factors: value, profitability, investments, momentum, and betting-against-beta can all be used to hedge co-skewness risk.
Keywords: Physical distributions, individual stocks, option implied, physical co-skewness
JEL Classification: G00, G11, G12, G13
Suggested Citation: Suggested Citation