DP7686 Improving Portfolio Selection Using Option-Implied Volatility and Skewness
|Author(s):||Victor DeMiguel, Yuliya Plyakha, Raman Uppal, Grigory Vilkov|
|Publication Date:||February 2010|
|Keyword(s):||mean-variance, option-implied skewness, option-implied volatility, portfolio optimization, variance risk premium|
|JEL(s):||G11, G12, G13, G17|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=7686|
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.