Risk Premium Bounds: Slackness Tests and Return Predictions

Abstract

Martin (2017) and subsequent authors derive lower bounds for risk premia on the market portfolio and for individual stocks using option prices. If the bounds are tight and the options market is informationally efficient, then the bounds must be the best possible predictors of returns. We test the bounds conditionally and find that they are valid in all market conditions but are not tight in all market conditions. Slackness is significant and predictable. Adding predicted slackness to a bound produces a return predictor that is superior to using the bound alone.

Keywords: Risk premia, bounds, conditional tests, predictability

JEL Classification: G12, G13, G14