Inferring the Forward Looking Equity Risk Premium from Derivative Prices
AbstractThis paper considers the measurement of the equity risk premium in financial markets from a new perspective that picks up on a suggestion from Merton (1980) to use implied volatility of options on a market portfolio as a direct ex-ante estimate for market variance, and hence the risk premium. Here the time variation of the unobserved risk premium is modelled by a system of stochastic differential equations connected by arbitrage arguments between the spot equity market, the index futures and options on index futures. We motivate and analyse a mean-reverting form for the dynamics of the risk premium. Since the risk premium is not directly observable, information about its time varying conditional distribution is extracted using an unobserved component state space formulation of the system and Kalman filtering methodology. In order to cater for the time variation of volatility we use the option implied volatility in the dynamic equations for the index and its derivatives. This quantity is in a sense treated as a signal that impounds the markets ex-ante, forward looking, view on the equity risk premium. The results using monthly U.S. market data over the period January 1995 to June 2003 are presented and the model fit is found to be statistically significant using a number of measures. Comparisons with ex-post returns indicate that such historical measures may be understating the market risk premium.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.
Bibliographic InfoArticle provided by De Gruyter in its journal Studies in Nonlinear Dynamics & Econometrics.
Volume (Year): 8 (2004)
Issue (Month): 1 (March)
Contact details of provider:
Web page: http://www.degruyter.com
You can help add them by filling out this form.
CitEc Project, subscribe to its RSS feed for this item.
- Ramaprasad Bhar, 2010. "Stochastic Filtering With Applications In Finance:," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., World Scientific Publishing Co. Pte. Ltd., number 7736.
- Bhar, Ramaprasad & Hamori, Shigeyuki, 2007. "Co-movement in the price of risk of aggregate equity markets," Economic Systems, Elsevier, Elsevier, vol. 31(3), pages 256-271, September.
- Eckhard Platen & Wolfgang Runggaldier, 2007.
"A Benchmark Approach to Portfolio Optimization under Partial Information,"
Research Paper Series, Quantitative Finance Research Centre, University of Technology, Sydney
191, Quantitative Finance Research Centre, University of Technology, Sydney.
- Eckhard Platen & Wolfgang Runggaldier, 2007. "A Benchmark Approach to Portfolio Optimization under Partial Information," Asia-Pacific Financial Markets, Springer, Springer, vol. 14(1), pages 25-43, March.
- Eckhard Platen & Wolfgang Runggaldier, 2004.
"A Benchmark Approach to Filtering in Finance,"
Asia-Pacific Financial Markets, Springer,
Springer, vol. 11(1), pages 79-105, March.
- Eckhard Platen & Wolfgang Runggaldier, 2002. "A Benchmark Approach to Filtering in Finance," Research Paper Series, Quantitative Finance Research Centre, University of Technology, Sydney 77, Quantitative Finance Research Centre, University of Technology, Sydney.
- Ren-Her Wang & John Aston & Cheng-Der Fuh, 2010. "The Role of Additional Information in Option Pricing: Estimation Issues for the State Space Model," Computational Economics, Society for Computational Economics, Society for Computational Economics, vol. 36(4), pages 283-307, December.
- Bhar, Ramaprasad & Nikolova, Biljana, 2013. "Measuring the interconnectedness of financial institutions," Economic Systems, Elsevier, Elsevier, vol. 37(1), pages 17-29.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Peter Golla).
If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.
If references are entirely missing, you can add them using this form.
If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.
If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.
Please note that corrections may take a couple of weeks to filter through the various RePEc services.