Option-Implied Equity Risk and the Cross-Section of Stock Returns

Posted: 28 Mar 2016 Last revised: 24 Apr 2021

See all articles by Te-Feng Chen

Te-Feng Chen

Hong Kong Polytechnic University

San-Lin Chung

National Taiwan University - Department of Finance

Wei-Che Tsai

Oregon State University; National Sun Yat-sen University - Department of Finance

Date Written: March 28, 2016

Abstract

Using forward-looking information in the options market, we introduce a new method for better identifying systematic market risk as a predictor for the cross-section of stock returns. Empirical results show that there is a significantly positive relation between our option-implied beta and subsequent stock returns, in which a long-short portfolio formed on the option-implied beta generates an average monthly risk-adjusted return of 0.96%. In support of its economic significance, we further find that our option-implied beta significantly predicts the future realized betas and that the associated risk premium is a strong predictor of future market returns.

Keywords: Idiosyncratic skewness; option-implied beta; expected stock returns; equity risk; equity options

Suggested Citation

Chen, Te-Feng and Chung, San-Lin and Tsai, Wei-Che, Option-Implied Equity Risk and the Cross-Section of Stock Returns (March 28, 2016). Financial Analysts Journal, Forthcoming, Available at SSRN: https://ssrn.com/abstract=2755440

Te-Feng Chen

Hong Kong Polytechnic University ( email )

Hung Hom, Kowloon
Hong Kong
+852 3400 3856 (Phone)

San-Lin Chung

National Taiwan University - Department of Finance ( email )

Taipei, 106
Taiwan
886-2-33661084 (Phone)
886-2-23660764 (Fax)

HOME PAGE: http://www.fin.ntu.edu.tw/~slchung/

Wei-Che Tsai (Contact Author)

Oregon State University ( email )

Corvallis, OR 97331
United States

National Sun Yat-sen University - Department of Finance ( email )

No.70, Lianhai Rd., Gushan District,
Kaohsiung City
Taiwan

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