IDEAS home Printed from https://ideas.repec.org/a/bpj/sndecm/v8y2004i1n3.html
   My bibliography  Save this article

Inferring the Forward Looking Equity Risk Premium from Derivative Prices

Author

Listed:
  • Bhar Ramaprasad

    (The University of New South Wales)

  • Chiarella Carl

    (University of Technology, Sydney, Australia)

  • Runggaldier Wolfgang J.

    (University of Padova, Italy)

Abstract

This 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 market's 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.

Suggested Citation

  • Bhar Ramaprasad & Chiarella Carl & Runggaldier Wolfgang J., 2004. "Inferring the Forward Looking Equity Risk Premium from Derivative Prices," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 8(1), pages 1-26, March.
    • Handle: RePEc:bpj:sndecm:v:8:y:2004:i:1:n:3
    DOI: 10.2202/1558-3708.1141
    as

    Download full text from publisher

    File URL: https://doi.org/10.2202/1558-3708.1141
    Download Restriction: For access to full text, subscription to the journal or payment for the individual article is required.
    File URL: https://libkey.io/10.2202/1558-3708.1141?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Bollerslev, Tim & Engle, Robert F & Wooldridge, Jeffrey M, 1988. "A Capital Asset Pricing Model with Time-Varying Covariances," Journal of Political Economy, University of Chicago Press, vol. 96(1), pages 116-131, February.
    2. Evans, Martin D D, 1994. "Expected Returns, Time-Varying Risk, and Risk Premia," Journal of Finance, American Finance Association, vol. 49(2), pages 655-679, June.
    3. Chan, K. C. & Karolyi, G. Andrew & Stulz, ReneM., 1992. "Global financial markets and the risk premium on U.S. equity," Journal of Financial Economics, Elsevier, vol. 32(2), pages 137-167, October.
    4. Babbs, Simon H. & Nowman, K. Ben, 1999. "Kalman Filtering of Generalized Vasicek Term Structure Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 34(1), pages 115-130, March.
    5. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, April.
    6. Bekaert, Geert & Harvey, Campbell R, 1995. "Time-Varying World Market Integration," Journal of Finance, American Finance Association, vol. 50(2), pages 403-444, June.
    7. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April.
    8. Christian Jochum, 1999. "Volatility spillovers and the price of risk: Evidence from the Swiss stock market," Empirical Economics, Springer, vol. 24(2), pages 303-322.
    9. Yacine Aït-Sahalia & Andrew W. Lo, 1998. "Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices," Journal of Finance, American Finance Association, vol. 53(2), pages 499-547, April.
    10. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    11. Merton, Robert C., 1980. "On estimating the expected return on the market : An exploratory investigation," Journal of Financial Economics, Elsevier, vol. 8(4), pages 323-361, December.
    12. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-384, March.
    13. Bos, T & Newbold, P, 1984. "An Empirical Investigation of the Possibility of Stochastic Systematic Risk in the Market Model," The Journal of Business, University of Chicago Press, vol. 57(1), pages 35-41, January.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Eckhard Platen & Wolfgang Runggaldier, 2004. "A Benchmark Approach to Filtering in Finance," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 11(1), pages 79-105, March.
    2. Eckhard Platen & Wolfgang Runggaldier, 2007. "A Benchmark Approach to Portfolio Optimization under Partial Information," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 14(1), pages 25-43, March.
    3. 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, Springer;Society for Computational Economics, vol. 36(4), pages 283-307, December.
    4. Bhar, Ramaprasad & Hamori, Shigeyuki, 2007. "Co-movement in the price of risk of aggregate equity markets," Economic Systems, Elsevier, vol. 31(3), pages 256-271, September.
    5. Ramaprasad Bhar, 2010. "Stochastic Filtering with Applications in Finance," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 7736, January.
    6. Bhar, Ramaprasad & Nikolova, Biljana, 2013. "Measuring the interconnectedness of financial institutions," Economic Systems, Elsevier, vol. 37(1), pages 17-29.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Ram Bhar & Carl Chiarella, 2000. "Infering Forward Looking Financial Market Risk Premia from Derivatives Prices," Research Paper Series 42, Quantitative Finance Research Centre, University of Technology, Sydney.
    2. Ram Bhar & Carl Chiarella & Wolfgang Runggaldier, 2001. "Filtering Equity Risk Premia From Derivative Prices," Research Paper Series 69, Quantitative Finance Research Centre, University of Technology, Sydney.
    3. Barr, David G. & Priestley, Richard, 2004. "Expected returns, risk and the integration of international bond markets," Journal of International Money and Finance, Elsevier, vol. 23(1), pages 71-97, February.
    4. Tom A. FEARNLEY, 2002. "Estimation of an International Capital Asset Pricing Model with Stocks and Government Bonds," FAME Research Paper Series rp95, International Center for Financial Asset Management and Engineering.
    5. Li, Yuming, 1998. "Expected stock returns, risk premiums and volatilities of economic factors1," Journal of Empirical Finance, Elsevier, vol. 5(2), pages 69-97, June.
    6. Harvey, Campbell R., 2001. "The specification of conditional expectations," Journal of Empirical Finance, Elsevier, vol. 8(5), pages 573-637, December.
    7. Carl Chiarella & Roberto Dieci & Xue-Zhong He, 2013. "Time-varying beta: a boundedly rational equilibrium approach," Journal of Evolutionary Economics, Springer, vol. 23(3), pages 609-639, July.
    8. Suthawan Prukumpai, 2015. "Time-varying Industrial Portfolio Betas under the Regime-switching Model: Evidence from the Stock Exchange of Thailand," Applied Economics Journal, Kasetsart University, Faculty of Economics, Center for Applied Economic Research, vol. 22(2), pages 54-76, December.
    9. Turan Bali & Kamil Yilmaz, 2009. "The Intertemporal Relation between Expected Return and Risk on Currency," Koç University-TUSIAD Economic Research Forum Working Papers 0909, Koc University-TUSIAD Economic Research Forum, revised Nov 2009.
    10. Prukumpai, Suthawan, 2015. "Time-varying Industrial Portfolio Betas under the Regime-switching Model:Evidence from the Stock Exchange of Thailand," Asian Journal of Applied Economics, Kasetsart University, Center for Applied Economics Research, vol. 22(2), December.
    11. De Santis, Giorgio & Gerard, Bruno, 1998. "How big is the premium for currency risk?," Journal of Financial Economics, Elsevier, vol. 49(3), pages 375-412, September.
    12. Bali, Turan G., 2008. "The intertemporal relation between expected returns and risk," Journal of Financial Economics, Elsevier, vol. 87(1), pages 101-131, January.
    13. Ramaprasad Bhar, 2010. "Stochastic Filtering with Applications in Finance," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 7736, January.
    14. Manuel Ammann & Michael Verhofen, 2006. "The Effect of Market Regimes on Style Allocation," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 20(3), pages 309-337, September.
    15. Anders Johansson, 2009. "An analysis of dynamic risk in the Greater China equity markets," Journal of Chinese Economic and Business Studies, Taylor & Francis Journals, vol. 7(3), pages 299-320.
    16. He, Hui & Yang, Jiawen, 2011. "Regime-switching analysis of ADR home market pass-through," Journal of Banking & Finance, Elsevier, vol. 35(1), pages 204-214, January.
    17. Ang, Andrew & Kristensen, Dennis, 2012. "Testing conditional factor models," Journal of Financial Economics, Elsevier, vol. 106(1), pages 132-156.
    18. Francis, Bill B. & Hasan, Iftekhar & Hunter, Delroy M., 2008. "Does hedging tell the full story? : Reconciling differences in US aggregate and industry-level exchange rate risk premia," Research Discussion Papers 14/2008, Bank of Finland.
    19. Javid, Attiya Yasmin & Ahmad, Eatzaz, 2008. "Testing multifactor capital asset pricing model in case of Pakistani market," MPRA Paper 37341, University Library of Munich, Germany.
    20. repec:zbw:bofrdp:2008_014 is not listed on IDEAS
    21. Juan Carlos Escanciano & Juan Carlos Pardo-Fernández & Ingrid Van Keilegom, 2017. "Semiparametric Estimation of Risk–Return Relationships," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 35(1), pages 40-52, January.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bpj:sndecm:v:8:y:2004:i:1:n:3. See general information about how to correct material in RePEc.

    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 CitEc recognized a bibliographic reference but did not link an item in RePEc 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 RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Peter Golla (email available below). General contact details of provider: https://www.degruyter.com .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.