An examination of ex ante risk and return in the cross-section using option-implied information

Abstract

This paper examines cross-sectional relations between ex ante expected returns and betas. As a proxy for ex ante expected returns, we use implied returns obtained from the risk-adjusted option pricing model suggested in this paper. We find that implied returns have a positive and significant cross-sectional relation with implied betas in all maturity groups considered. This significant relation is maintained regardless of the inclusion of the well-known CAPM-anomaly variables such as firm size, book-to-market, past returns, earnings-to-price ratio, and liquidity. Ex ante market risk premium estimates have a statistical significance as well as an economic significance in that they contain significant forward-looking information on future macroeconomic conditions. Thus, market betas are priced on an ex ante basis.