Market Timing with Option-Implied Distributions in an Exponentially Tempered Stable Lévy Market
Manuel Guerra and
No 2019/74, Working Papers REM from ISEG - Lisbon School of Economics and Management, REM, Universidade de Lisboa
This paper explores the empirical implementation of a dynamic asset allocation strategy using option-implied distributions when the underlying risky asset price is modeled by an exponential Lévy process. One month risk-neutral densities are extracted from option prices and are subsequently transformed to the risk-adjusted, or real-world densities. Optimal portfolios consisting of a risky and risk-free asset rebalanced on a monthly basis are then constructed and their performance analyzed. It is found that the portfolios formed using option-implied expectations under the Lévy market assumption, which are flexible enough to capture the higher moments of the implied distribution, are far more robust to left-tail market risks and offer statistically significant improvements to risk-adjusted performance when investor risk aversion is low, however this diminishes as risk aversion increases.
Keywords: Asset Allocation; Lévy Processes; Option-Implied Distributions; Portfolio Optimization (search for similar items in EconPapers)
JEL-codes: C10 C51 G11 G13 G17 (search for similar items in EconPapers)
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Persistent link: https://EconPapers.repec.org/RePEc:ise:remwps:wp0742019
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