Working Paper: CEPR ID: DP7686
Authors: Victor Demiguel; Yuliya Plyakha; Raman Uppal; Grigory Vilkov
Abstract: Our objective in this paper is to examine whether one can use option-implied information to improve mean-variance portfolio selection with a large number of stocks, and to document which aspects of option-implied information are most useful for improving the out-of-sample performance of mean-variance portfolios. To calculate the optimal mean-variance portfolio weights, one needs to estimate for each stock its volatility, correlations with all other stocks, and expected return. Our empirical evidence shows that, while using the option-implied volatilities and correlations does not improve significantly the portfolio variance, Sharpe ratio, and certainty-equivalent return, exploiting information about expected returns that is contained in the volatility risk premium and option-implied skewness increases substantially Sharpe ratios and certainty-equivalent returns, but this is accompanied by higher portfolio turnover.
Keywords: Mean-variance; Option-implied skewness; Option-implied volatility; Portfolio optimization; Variance risk premium
JEL Codes: G11; G12; G13; G17
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Option-implied volatilities (C69) | Portfolio volatility (G17) |
| Option-implied volatilities (C69) | Sharpe ratio (G11) |
| Option-implied skewness and volatility risk premium (C58) | Sharpe ratios (G12) |
| Option-implied skewness and volatility risk premium (C58) | Certainty-equivalent returns (D81) |