Abstract
In this research we describe how forward-looking information on the statistical properties of an asset can be extracted directly from options market data and demonstrate how this can be practically applied to portfolio management. Although the extraction of a forward-looking risk-neutral distribution is well-established in the literature, the issue of estimating distributions in an illiquid market is not. We use the deterministic SVI volatility model to estimate weekly risk-neutral distribution surfaces. The issue of calibration with sparse and noisy data is considered at length and a simple but robust fitting algorithm is proposed. We further attempt to extract real-world implied information by implementing the recovery theorem introduced by Ross (2015). Recovery is an ill-posed problem that requires careful consideration. We describe a regularisation methodology for extracting real-world implied distributions and implement this method on a history of SVI volatility surfaces. We analyse the first four moments from the implied risk-neutral and real-world implied distributions and use them as signals within a simple tactical asset allocation framework, finding promising results.Keywords: Option-implied distributions; SVI volatility model; Ross recovery theorem; Tikhonov regularisation; illiquid derivative markets
Highlights
1.1 An important requirement for optimal portfolio construction is an understanding of the future possible returns of the constituent assets
There has been little empirical research done to date—in liquid and illiquid markets alike—on extracting real-world implied information using the recovery theorem introduced by Ross (2015)
We address both these issues by considering in detail the estimation and application of risk-neutral and real-world option-implied distributions in an illiquid market setting
Summary
1.1 An important requirement for optimal portfolio construction is an understanding of the future possible returns of the constituent assets. 1.5 Breeden & Litzenberger (1978) proved that the forward-looking risk-neutral return distribution (RND) could be extracted directly from an arbitrage-free derivatives market provided that one knows the European option prices for all levels of the underlying. This result gave investors the means to estimate the forward-looking RND for a given term from the implied volatility skew for that same term. General option-implied data applications are discussed, recovered real-world distribution moments are compared to their risk-neutral counterparts and a tactical asset allocation example using implied information is presented.
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