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

  • 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)

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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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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