Generalized Bounds on the Conditional Expected Excess Return on Individual Stocks

We derive generalized bounds on conditional expected excess returns that can be computed from option prices. The generalized lower bound may serve as an expected excess return proxy for individual and basket-type assets, is conditionally tight, accounts for the entire risk-neutral distribution of returns, and outperforms existing variance-based models in out-of-sample predictions. Bounds calibrated to realized returns correspond to reasonable risk aversion and prudence. On average, expected stock returns given by the bounds decrease on even weeks of the Federal Open Market Committee cycle. Crosssectional tests deliver a reasonable market risk premium.

Automated summary

This study derives generalized bounds on conditional expected excess returns that can be computed from option prices. The generalized lower bound serves as an expected excess return proxy for individual and basket-type assets, accounting for the entire risk-neutral distribution of returns and outperforming existing variance-based models in out-of-sample predictions. Bounds calibrated to realized returns correspond to reasonable risk aversion and prudence. Moreover, the expected stock returns given by the bounds decrease on even weeks of the Federal Open Market Committee cycle, and cross-sectional tests validate a reasonable market risk premium.