Do risk-neutral moments incorporate forward-looking information?

Abstract

“Stocks are bought on expectations, not facts.” -Gerald M. Loeb

The stock market is constantly experiencing fluctuation, with prices moving every second. To the general public, these stock prices are reflections of the company’s intrinsic values and its fundamentals. However, we believe that these numbers are no mere values; instead, they carry an underlying model which encompasses information about market expectations. It is believed that these prices may have predictive power over future prices. In our study, we extracted this forward-looking information from the US option prices using the Black-Scholes Model. We performed tests to determine correlations between the parameters that define the implied volatility that is embedded in the option prices. Then we estimated a multivariate time series model to define the underlying relationship between risk neutral moments and the returns from stock options.