Option augmented density forecasts of market returns with monotone pricing kernel

Brendan Beare and Asad Dossani

Quantitative Finance, 2018, vol. 18, issue 4, 623-635

Abstract: Basic financial theory indicates that the ratio of the conditional density of the future value of a market index and the corresponding risk neutral density should be monotone, but a sizeable empirical literature finds otherwise. We therefore consider an option augmented density forecast of the market return obtained by transforming a baseline density forecast estimated from past excess returns so as to monotonize its ratio with a risk neutral density estimated from current option prices. To evaluate our procedure, we compare baseline and option augmented monthly density forecasts for the S&P 500 index over the period 1997–2013. We find that monotonizing the pricing kernel leads to a modest improvement in the calibration of density forecasts. Supplementary results supportive of this finding are given for market indices in France, Germany, Hong Kong, Japan and the UK.

Date: 2018
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DOI: 10.1080/14697688.2017.1383626

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