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Market Timing with Option-Implied Distributions: A Forward-Looking Approach

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Author Info

  • Alexandros Kostakis

    ()
    (Liverpool Management School, University of Liverpool, Liverpool L69 7ZH, United Kingdom)

  • Nikolaos Panigirtzoglou

    ()
    (Department of Economics, University of London, London E1 4NS, United Kingdom)

  • George Skiadopoulos

    ()
    (Department of Banking and Financial Management, University of Piraeus, Piraeus 18534, Greece; Financial Options Research Centre, Warwick Business School, University of Warwick, Coventry CV4 7AL, United Kingdom; and Cass Business School, City University London, London EC1Y 8TZ, United Kingdom)

Abstract

We address the empirical implementation of the static asset allocation problem by developing a forward-looking approach that uses information from market option prices. To this end, we extract constant maturity S&P 500 implied distributions and transform them to the corresponding risk-adjusted ones. Then we form optimal portfolios consisting of a risky and a risk-free asset and evaluate their out-of-sample performance. We find that the use of risk-adjusted implied distributions times the market and makes the investor better off than if she uses historical returns' distributions to calculate her optimal strategy. The results hold under a number of evaluation metrics and utility functions and carry through even when transaction costs are taken into account. Not surprisingly, the reported market timing ability deteriorated during the recent subprime crisis. An extension of the approach to a dynamic asset allocation setting is also presented. This paper was accepted by Wei Xiong, finance.

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File URL: http://dx.doi.org/10.1287/mnsc.1110.1346
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Bibliographic Info

Article provided by INFORMS in its journal Management Science.

Volume (Year): 57 (2011)
Issue (Month): 7 (July)
Pages: 1231-1249

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Handle: RePEc:inm:ormnsc:v:57:y:2011:i:7:p:1231-1249

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Related research

Keywords: asset allocation; option-implied distributions; market timing; performance evaluation; portfolio choice; risk aversion;

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Cited by:
  1. Brinkmann, Felix & Kempf, Alexander & Korn, Olaf, 2013. "Forward-looking measures of higher-order dependencies with an application to portfolio selection," CFR Working Papers 13-08, University of Cologne, Centre for Financial Research (CFR).
  2. Alejandro Bernales & Massimo Guidolin, 2012. "Can We Forecast the Implied Volatility Surface Dynamics of Equity Options? Predictability and Economic Value Tests," Working Papers 456, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  3. Kempf, Alexander & Korn, Olaf & Saßning, Sven, 2014. "Portfolio optimization using forward-looking information," CFR Working Papers 11-10 [rev.], University of Cologne, Centre for Financial Research (CFR).
  4. Kempf, Alexander & Korn, Olaf & Saßning, Sven, 2011. "Portfolio optimization using forward-looking information," CFR Working Papers 11-10, University of Cologne, Centre for Financial Research (CFR).
  5. Brinkmann, Felix & Kempf, Alexander & Korn, Olaf, 2014. "Forward-looking measures of higher-order dependencies with an application to portfolio selection," CFR Working Papers 13-08 [rev.], University of Cologne, Centre for Financial Research (CFR).
  6. Kaeck, Andreas, 2013. "Asymmetry in the jump-size distribution of the S&P 500: Evidence from equity and option markets," Journal of Economic Dynamics and Control, Elsevier, vol. 37(9), pages 1872-1888.
  7. Daskalaki, Charoula & Skiadopoulos, George, 2011. "Should investors include commodities in their portfolios after all? New evidence," Journal of Banking & Finance, Elsevier, vol. 35(10), pages 2606-2626, October.
  8. Jiang, George J. & Konstantinidi, Eirini & Skiadopoulos, George, 2012. "Volatility spillovers and the effect of news announcements," Journal of Banking & Finance, Elsevier, vol. 36(8), pages 2260-2273.

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