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Improving Portfolio Selection Using Option-Implied Volatility and Skewness

Published online by Cambridge University Press:  02 January 2014

Victor DeMiguel ,
Yuliya Plyakha ,
Raman Uppal  and
Grigory Vilkov
Victor DeMiguel
Affiliation:
avmiguel@london.edu, London Business School, 6 Sussex Place, Regent’s Park, London NW1 4SA, United Kingdom;
Yuliya Plyakha
Affiliation:
plyakha@gmx.de, Luxembourg School of Finance, University of Luxembourg,4, rue Albert Borschette, L-1246 Luxembourg;
Raman Uppal
Affiliation:
raman.uppal@edhec.edu, Edhec Business School, 10 Fleet Place, Ludgate, London EC4M 7RB, United Kingdom and Center for Economic and Policy Research (CEPR);
Grigory Vilkov
Affiliation:
vilkov@vilkov.net, Goethe University Frankfurt, Finance Department, Grüneburgplatz 1 / Uni-Pf H 25, Frankfurt am Main,D-60323, Germany.
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Abstract

Our objective in this paper is to examine whether one can use option-implied information to improve the selection of mean-variance portfolios with a large number of stocks, and to document which aspects of option-implied information are most useful to improve their out-of-sample performance. Portfolio performance is measured in terms of volatility, Sharpe ratio, and turnover. Our empirical evidence shows that using option-implied volatility helps to reduce portfolio volatility. Using option-implied correlation does not improve any of the metrics. Using option-implied volatility, risk premium, and skewness to adjust expected returns leads to a substantial improvement in the Sharpe ratio, even after prohibiting short sales and accounting for transaction costs.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 48 , Issue 6 , December 2013 , pp. 1813 - 1845
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2013 

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