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Option-based Equity Risk Premiums

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  • Alan L. Lewis

Abstract

We construct the term structure of the (forward-looking, US market) equity risk premium from SPX option chains. The method is "model-light". Risk-neutral probability densities are estimated by fitting $N$-component Gaussian mixture models to option quotes, where $N$ is a small integer (here 4 or 5). These densities are transformed to their real-world equivalents by exponential tilting with a single parameter: the Coefficient of Relative Risk Aversion $\kappa$. From history, I estimate $\kappa = 3 \pm 0.5$. From the inferred real-world densities, the equity risk premium is readily calculated. Three term structures serve as examples.

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  • Alan L. Lewis, 2019. "Option-based Equity Risk Premiums," Papers 1910.14522, arXiv.org, revised Apr 2020.
    • Handle: RePEc:arx:papers:1910.14522
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    References listed on IDEAS

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    1. Back, Kerry, 2010. "Asset Pricing and Portfolio Choice Theory," OUP Catalogue, Oxford University Press, number 9780195380613.
    2. Matthias Fengler, 2009. "Arbitrage-free smoothing of the implied volatility surface," Quantitative Finance, Taylor & Francis Journals, vol. 9(4), pages 417-428.
    3. repec:bla:jfinan:v:59:y:2004:i:1:p:407-446 is not listed on IDEAS
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