Abstract
Using option prices, a new method for estimating the term structure of expected stock returns (equity curve) is proposed. We analyse how the equity curve relates to future stock returns and obtain three main results. First, a higher level of the equity curve is associated with higher future stock returns. Second, a positive slope is followed by future realized returns which are lower in the short term (1 month) than in the long term (1 quarter or 1 year). Third, a steeper slope (either positive or negative) is associated with a larger absolute difference between short-term and long-term returns. Therefore, the equity curve is consistent with theoretical predictions. We also analyse an investment strategy that uses the slope of the equity curve to determine the allocation to stocks. This strategy earns an outperformance of up to 200 basis points per annum.
Highlights
The expected return of stocks is one of the most important numbers in financial theory and investment practice
We find that the forecasting characteristics of the equity curve are largely consistent with rational expectations, which implies that information from option prices is a valuable source to predict future stock returns
This paper has proposed a new method to derive the term structure of expected stock returns
Summary
The expected return of stocks is one of the most important numbers in financial theory and investment practice. A high (low) dividend yield forecasts high (low) future stock returns.. Some theoretical approaches have addressed the term structure of expected stock returns (e.g., Lettau and Wachter 2011; Croce et al 2015). Large information providers like Bloomberg do not offer such a tool. This may seem surprising, since the term structure of interest rates is observed by investors and academics alike. The term spread in interest rates is widely used to forecast future economic activity in the US and other countries (e.g., Estrella and Hardouvelis 1991; Estrella and Mishkin 1998; Rudebusch and Williams 2009)
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