Option-Implied Equity Premium Predictions via Entropic TiltinG

We propose a new method to improve density forecasts of the equity premium us- ing information from options markets. We obtain predictive densities from a stae-of-the-art stochastic volatility (SV) model, which we then tilt towards the second moment of the risk-neutral distribution implied by options prices, while imposing a non-negativity constraint on the equity premium. By combining the backward-looking information contained in the SV model with the forward-looking information from options prices, our procedure delivers sharper predictive densities. Using density forecasts of the U.S. equity premium from January 1990 to December 2014, we find that tilting leads to more accurate predictions, both in terms of statistical and economic criteria.