Market Returns Dormant in Options Panels

Yoosoon Chang (), Youngmin Choi (), Soohun Kim () and Joon Park ()
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Yoosoon Chang: Indiana University, Department of Economics
Youngmin Choi: Baruch College (CUNY), Zicklin School of Business, Department of Economics and Finance
Soohun Kim: Korea Advanced Institute of Science and Technology (KAIST), College of Business
Joon Park: Indiana University, Department of Economics

CAEPR Working Papers from Center for Applied Economics and Policy Research, Department of Economics, Indiana University Bloomington

Abstract: This paper develops a novel functional predictive regression framework linking option-implied distributions to stock market returns, motivated by the fundamental link between risk-neutral and physical densities. Using extensive S&P 500 option panels, our model exhibits significant forecasting power, achieving robust out-of-sample R2 exceeding 4% and outperforming traditional predictors. Superior performance arises from leveraging the full spectrum of the risk-neutral density via functional principal components. Our analysis reveals forecasting success stems from nuanced variations in risk-neutral densities beyond conventional finite moments, underscoring the predictive value of distributional shape and higher-order information, and demonstrates potential economic gains through a market-timing strategy.

Keywords: functional predictive regression; market risk premium; option market; return predictability; risk-neutral measure; stochastic discount factor (search for similar items in EconPapers)
Pages: 72 pages
Date: 2025-07
New Economics Papers: this item is included in nep-inv
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