Mathematical Finance and Probability Seminars (Since covid these events are taking place online.)

Estimating expected returns from option prices with its application in portfolio selection

Tuesday, April 10, 2012 at 11:00am - 12:00pm

Speaker: Huaqiang Ma, University of Maryland, Wells Fargo Securities

Traditionally, the expected return is estimated from the historical data through the classic asset pricing models and their variations. However, because the realized returns are so volatile, it requires decades or even longer time period of data to attain relatively accurate estimates. Furthermore, it is questionable to extrapolate the expected return from the historical data because the return is determined by future uncertainty. Here a novel method is proposed to alleviate these problems. Since the option prices represent future uncertainty and investors’ risk preferences, in this study, the expected return is estimated from option calibration through the numeraire portfolio pricing method, which directly links option prices to the expected return. From our calculation, the estimated expected return from our method is indifferent to the realized return when the major risk factors are considered. This demonstrates that the numeraire portfolio pricing method can provide a good estimator for the expected return. Furthermore, optimal portfolios from the numeraire-portfolio estimated expected returns are shown to be superior to the ones constructed from the expected returns based on historical data. This is work under the supervision of Prof. Dilip Madan.

Speaker: Huaqiang Ma, University of Maryland, Wells Fargo Securities

Location   Hill 705