1 - How useful are implied distributions? Evidence from stock-index options - Dec 1999

Option prices can be used to construct implied (risk-neutral) distributions, but it remains to be proven whether these are useful either in relation to forecasting subsequent market movements or in revealing investor sentiment. We estimate the implied distribution as a mixture of two lognormals and then test its one-day-ahead forecasting performance, using 1987-97 data on LIFFE’s FTSE-100 index options. We find that the two-lognormal method is much better than the one-lognormal (Black/Scholes) approach at fitting observed option prices, but it is only marginally better at predicting out-of-sample prices. A closer analysis of four “crash” periods confirms that the shape of the implied distribution does not anticipate such events but merely reflects their passing. Similarly, during three British elections the implied distributions take on interesting shapes but these are not closely related to prior information about the likely outcomes. In short, while we cannot reject the hypothesis that implied distributions reflect market sentiment, we find that sentiment (thus measured) has little forecasting ability.