Option-implied preferences adjustments, density forecasts, and the equity risk premium |
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Authors: | Francisco Alonso Roberto Blanco Gonzalo Rubio |
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Institution: | 1. Servicio de Estudios, Banco de Espa?a, Alcalá 48, 28014, Madrid, Spain 2. Universidad CEU Cardenal Herrera, Valencia, Spain
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Abstract: | The main objective of this paper is to analyse the value of information contained in prices of options on the IBEX 35 index
at the Spanish Stock Exchange Market. The forward looking information is extracted using implied risk-neutral density functions
estimated by a mixture of two-lognormals and several alternative risk adjustments. Our results show that, between October
1996 and March 2000, we can reject the hypothesis that the risk-neutral densities provide accurate predictions of the distributions
of future realisations of the IBEX 35 index at 4- and 8-week horizons. When forecasting through risk-adjusted densities the
performance of this period is statistically improved and we no longer reject that hypothesis. We show that risk adjustments
based on a power specification for the stochastic discount factor—which is the approach used so far in the literature that
derives the objective density function from option prices- generates an excessive volatility of risk premia. We use alternative
risk adjustments and find that the forecasting performance of the distribution improves slightly in some cases when risk aversion
is allowed to be time-varying. Finally, from October 1996 to December 2004, the ex-ante risk premium perceived by investors
and that are embedded in option prices is between 12 and 18% higher than the premium required to compensate the same investors
for the realised volatility in stock market returns.
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Keywords: | Risk adjustments Option-implied densities Forecasting performance Equity-risk premium |
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