Option Prices as Predictors of Aggregate Stock Returns

39 Pages Posted: 17 May 2005

See all articles by R. Brian Balyeat

R. Brian Balyeat

Xavier University - Department of Finance

Bilal Erturk

Texas A&M University - Department of Finance

Date Written: October 11, 2005

Abstract

The relative prices of S&P 500 index call and put options convey information regarding the future return of the S&P 500 index realized over the life of the options. When call options are relatively more expensive than put options, the index earns higher returns. Specifically, the natural log of the ratio of the out-of-the-money call price to the equally out-of-the-money put price at differing moneyness levels and maturities is positively related to the return of the index realized over the life of the options. This predictability is robust to controls for the cost of carry, past returns, implied volatility, and upper moments of the underlying. Furthermore, the results do not appear to be driven by the sign of the log ratio. Portfolios of the underlying formed when the log ratio of the options prices is positive (when call options are more expensive) statistically outperform portfolios similarly formed when the log ratio is negative (when put options are more expensive).

Keywords: Future returns, predictability, option values, cubic spline, implied volatility

JEL Classification: G12, G13

Suggested Citation

Balyeat, Ralph Brian and Erturk, Bilal, Option Prices as Predictors of Aggregate Stock Returns (October 11, 2005). Available at SSRN: https://ssrn.com/abstract=721345 or http://dx.doi.org/10.2139/ssrn.721345

Ralph Brian Balyeat (Contact Author)

Xavier University - Department of Finance ( email )

3800 Victory Parkway
Cincinnati, OH 45207
United States
513 745-3013 (Phone)
513 745-4383 (Fax)

Bilal Erturk

Texas A&M University - Department of Finance ( email )

360 Wehner
College Station, TX 77843-4218
United States

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