We propose a new method to improve density forecasts of the equity premium using information from options markets. We obtain predictive densities from stochastic volatility (SV) and GARCH models, which we then tilt using the second moment of the risk-neutral distribution implied by options prices while imposing a non-negativity constraint on the equity premium. By combining the backward-looking information contained in the GARCH and SV models with the forward-looking information from options prices, our procedure improves the performance of predictive densities. Using density forecasts of the U.S. equity premium from January 1990 to December 2014, we find that tilting leads to more accurate predictions using statistical and economic criteria.

Additional Metadata
Keywords density forecasts, entropic tilting, equity premium, options, variance risk premium
Persistent URL dx.doi.org/10.1093/jjfinec/nby009
Journal Journal of Financial Econometrics
Citation
Metaxoglou, K, Pettenuzzo, D. (Davide), & Smith, A. (Aaron). (2019). Option-Implied Equity Premium Predictions via Entropic Tilting. Journal of Financial Econometrics, 17(4), 559–586. doi:10.1093/jjfinec/nby009