Expected Stock Returns and Option-Implied Rate of Return

Samuel Y. M. Ze-To

Department of Finance and Decision Sciences, Hong Kong Baptist University, Hong Kong.

DOI: 10.4236/jmf.2012.24030                

Abstract

This paper examines the predictability of implied required rate of return (R_OI) of individual stock in the cross-section of stock returns. The required rate of return of each stock is implied using its corresponding stock options and used in estimating the fundamental value of stock. The study finds that stocks with low price to fundamental value have higher future returns. The inferred R_OIOI

Keywords

Implied Rate of Return; Options

Conflicts of Interest

The authors declare no conflicts of interest.

References

[1]	T. G. Bali and A. Hovakimian, “Volatility Spreads and Expected Stock Returns,” Management Science, Vol. 50, No. 11, 2009, pp. 1797-1812. doi:10.1287/mnsc.1090.1063
[2]	A. Ang, R. J. Hodrick, Y. H. Xing and X. Y. Zhang, “The Cross-Section of Volatility and Expected Returns,” The Journal of Finance, Vol. 61, No. 1, 2006, pp. 259-299. doi:10.1111/j.1540-6261.2006.00836.x
[3]	E. F. Fama and K. R. French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial economic, Vol. 33, No. 1, 1993, pp. 3-56. doi:10.1016/0304-405X(93)90023-5
[4]	T. G. Bali and N. Cakici, “Idiosyncratic Volatility and Cross-Section of Expected Returns,” Journal of Financial and Quantitative Analysis, Vol. 43, No. 1, 2008, pp. 29-58.
[5]	A. Camara, S. L. Chung and Y. H. Wang, “Option Implied Cost of Equity and Its Properties,” Journal of Futures markets, Vol. 29, No. 7, 2009, pp. 599-629. doi:10.1002/fut.20372
[6]	G. Dissanaike and K. H. Lim, “The Sophisticated and the Simple: The Profitability of Contrarian Strategies,” European Financial Management, Vol. 16, No. 2, 2010, pp. 229-255. doi:10.1111/j.1468-036X.2008.00466.x
[7]	M. A. Keppler, “Further Evidence on the Predictability of International Equity Returns,” Journal of Portfolio Management, Vol. 18, No. 1, 1991, pp. 48-53. doi:10.3905/jpm.1991.409385
[8]	M. A. Keppler, “The Importance of Dividend Yields in Country Selection,” Journal of Portfolio Management, Vol. 17, No. 2, 1991, pp. 24-29. doi:10.3905/jpm.1991.409327
[9]	C. S. Asness, J. M. Liew and L. S. Ross, “Parallels between the Cross-Sectional Predictability of Stock and Country Returns,” Journal of Portfolio Management, Vol. 23, No. 3, 1997, pp. 79-86. doi:10.3905/jpm.1997.409606
[10]	M. C. Lee, J. Myers and B. Swaminathan, “What Is the Intrinsic Value of the Dow?” Journal of Finance, Vol. 54, No. 5, 1999, pp. 1693-1741. doi:10.1111/0022-1082.00164
[11]	L. Pástor and R. F. Stambaugh, “Comparing Asset Pricing Models: An Investment Perspective,” Journal of Financial Economics, Vol. 56, No. 3, 2000, pp. 335-381.
[12]	A. Nekrasov and P. K. Shroff, “Fundamentals-Based Risk Measurement in Valuation,” The Accounting Review, Vol. 84, No. 6, 2009, pp. 1983-2011. doi:10.2308/accr.2009.84.6.1983
[13]	M. Richardson and J. H. Stock, “Drawing Inferences from Statistics Based on Multi-Year Asset Returns,” Journal of Financial Economics, Vol. 25, No. 2, 1989, pp. 323-348. doi:10.1016/0304-405X(89)90086-X
[14]	E. F. Fama and K. R. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance, Vol. 47, No. 2, 1992, pp. 427-465. doi:10.1111/j.1540-6261.1992.tb04398.x