Does Information Content of Option Prices Add Value for Asset Allocation?

Vladimir Zdorovenin and Jacques Pézier
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Vladimir Zdorovenin: ICMA Centre, Henley Business School, University of Reading
Jacques Pézier: ICMA Centre, Henley Business School, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: The aim of this paper is to determine whether forward-looking option- implied returns forecasts lead to better out-of-sample portfolio performance than conventional time series models. We consider a simple two-asset setting with a risk-free asset and the S&P 500 index the risky asset with monthly allocation revisions. We carry out a comprehensive analysis with a wide range of time-series models, two risk-neutral density inference methods, two utility functions, and several performance metrics. Portfolios are compared over the period of January 1994 to April 2010. Our main contribution is to compare the merits of implied volatility smoothing and maximum entropy risk-neutral density estimation techniques. By using bid/ask quotes in place of the closing prices, we obtain smooth probability densities using the maximum entropy principle that outperform the probability densities obtained using the implied volatility smoothing method. We also identify which moments of the option-implied probability densities contribute most to portfolio performance.

Keywords: Risk-neutral density; Real-world density; Index options; Maximum entropy; Implied volatility smoothing; Optimal portfolio (search for similar items in EconPapers)
JEL-codes: C14 C22 C53 G11 G13 G17 (search for similar items in EconPapers)
Date: 2011-01
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Citations: View citations in EconPapers (2)

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