Information Content of Implied Probability Distributions: Empirical Studies of Japanese Stock Price Index Options

Empirical studies of the information content of option prices have focused on exploring whether implied volatility contains useful information regarding the future fluctuation of underlying asset prices. If expectation formation in the option markets reflects all the currently available information regarding future price movements, option prices will be useful in forecasting the price fluctuation of underlying assets. This paper extends such an analytical framework to implied probability distribution as a whole and examines its information content by using Japanese stock price index option data (on a daily basis) from mid-1989 to mid-1996. To this end, the following questions are examined: (1) whether the implied probability distribution is a good forecast of the subsequently realized distribution of stock price fluctuations, and (2) whether a leads and lags relationship exists between stock price changes and changes in the shape of the implied probability distribution. The estimation results show that (1) the implied probability distribution contains some information regarding future price movements, but its forecasting ability is not superior to that of the historical distribution, and (2) the shape of the implied probability distribution not only responds to stock price changes but also contains some information on forecasting stock price changes. However, it should be noted that such results are highly sensitive to the choice of sample period, suggesting that the information content depends on macroeconomic and financial market conditions. Therefore, the information contained in an implied probability distribution is difficult to interpret automatically as an information variable for monetary policy, and further studies are needed on how to make use of information contained in implied probability distributions.