The role of an option-implied distribution in improving an asset allocation model

Authors

  • Hafizah Bahaludin International Islamic University Malaysia
  • Mimi Hafizah Abdullah International Islamic University Malaysia

DOI:

https://doi.org/10.11113/mjfas.v16n1.1368

Keywords:

option prices, option-implied distribution, asset allocation model

Abstract

The objective of this paper is to extend the information embedded in option-implied distribution to asset allocation model. This paper examines whether a parameter estimated from an option-implied distribution can improve a minimum-variance portfolio which consists of many risky assets. The option-implied distribution under a risk-neutral assumption is called risk-neutral density (RND) whereas a risk-world density (RWD) is calculated by incorporating a risk-premium. The computation of option-implied distributions is based on the Dow Jones Industrial Average (DJIA) index options and its constituents. The data covers the period from January 2009 until December 2015. Portfolio performance is evaluated based on portfolio volatility and Sharpe ratio. The performance of a portfolio based on an option-implied distribution is compared to a naive diversification portfolio. The empirical evidence shows that for a portfolio based on an option-implied distribution, the volatility of the portfolio is reduced and the Sharpe ratio is increased.

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Published

02-02-2020