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Market Timing with Option-Implied Distributions in an Exponentially Tempered Stable Lévy Market

Author

Listed:
  • João Guerra
  • Manuel Guerra
  • Zachary Polaski

Abstract

This paper explores the empirical implementation of a dynamic asset allocation strategy using option-implied distributions when the underlying risky asset price is modeled by an exponential Lévy process. One month risk-neutral densities are extracted from option prices and are subsequently transformed to the risk-adjusted, or real-world densities. Optimal portfolios consisting of a risky and risk-free asset rebalanced on a monthly basis are then constructed and their performance analyzed. It is found that the portfolios formed using option-implied expectations under the Lévy market assumption, which are flexible enough to capture the higher moments of the implied distribution, are far more robust to left-tail market risks and offer statistically significant improvements to risk-adjusted performance when investor risk aversion is low, however this diminishes as risk aversion increases.

Suggested Citation

  • João Guerra & Manuel Guerra & Zachary Polaski, 2019. "Market Timing with Option-Implied Distributions in an Exponentially Tempered Stable Lévy Market," Working Papers REM 2019/74, ISEG - Lisbon School of Economics and Management, REM, Universidade de Lisboa.
    • Handle: RePEc:ise:remwps:wp0742019
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    File URL: https://rem.rc.iseg.ulisboa.pt/wps/pdf/REM_WP_074_2019.pdf
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    References listed on IDEAS

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    More about this item

    Keywords

    Asset Allocation; Lévy Processes; Option-Implied Distributions; Portfolio Optimization;
    All these keywords.

    JEL classification:

    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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