Market timing with option-implied distributions in an exponentially tempered stable Lévy market

Guerra, João; Guerra, Manuel; Polaski, Zachary

http://hdl.handle.net/10400.5/17445

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Authors

Guerra, João

Guerra, Manuel

Polaski, Zachary

Abstract(s)

This paper explores the empirical implementation of a dynamic asset allocation strategy using option-implied distributions when the underlying risky asset price is modeled by an exponential Lévy process. One month risk-neutral densities are extracted from option prices and are subsequently transformed to the risk-adjusted, or real-world densities. Optimal portfolios consisting of a risky and risk-free asset rebalanced on a monthly basis are then constructed and their performance analyzed. It is found that the portfolios formed using option-implied expectations under the Lévy market assumption, which are flexible enough to capture the higher moments of the implied distribution, are far more robust to left-tail market risks and offer statistically significant improvements to risk-adjusted performance when investor risk aversion is low, however this diminishes as risk aversion increases.

Keywords

Asset Allocation Lévy Processes Option-Implied Distributions Portfolio Optimization

URI

http://hdl.handle.net/10400.5/17445

Citation

Guerra, João, Manuel Guerra e Zachary Polaski (2019). "Market timing with option-implied distributions in an exponentially tempered stable Lévy market". Instituto Superior de Economia e Gestão – REM Working paper nº 074 - 2019