Market Timing with Option-Implied Distributions: A Forward-Looking Approach

Alexandros Kostakis, Nikolaos Panigirtzoglou, George Skiadopoulos

Management Science · 2011 · 113 citations · 61 references

Concepts

TL;DR

The paper develops a forward‑looking static asset‑allocation method using market option prices and extends it to a dynamic setting. They extract constant‑maturity S&P 500 implied distributions, adjust them for risk, construct optimal risky‑plus‑risk‑free portfolios, and evaluate out‑of‑sample performance, also extending the method to dynamic allocation. Using risk‑adjusted implied distributions improves out‑of‑sample performance over historical‑return‑based strategies across multiple metrics and utility functions, even with transaction costs, though performance weakened during the subprime crisis. Accepted by Wei Xiong, finance.

Abstract

We address the empirical implementation of the static asset allocation problem by developing a forward-looking approach that uses information from market option prices. To this end, we extract constant maturity S&P 500 implied distributions and transform them to the corresponding risk-adjusted ones. Then we form optimal portfolios consisting of a risky and a risk-free asset and evaluate their out-of-sample performance. We find that the use of risk-adjusted implied distributions times the market and makes the investor better off than if she uses historical returns' distributions to calculate her optimal strategy. The results hold under a number of evaluation metrics and utility functions and carry through even when transaction costs are taken into account. Not surprisingly, the reported market timing ability deteriorated during the recent subprime crisis. An extension of the approach to a dynamic asset allocation setting is also presented. This paper was accepted by Wei Xiong, finance.

References

61