Greeks-Neutral Option Excess Returns

Abstract

This study investigates the linkage between ex-ante expected greeks-neutral excess return (${\mathrm{EER}}^{\mathrm{GN}}$) and ex-post realized greeks-neutral excess return (${\mathrm{RER}}^{\mathrm{GN}}$). Employing the top-down framework, we show that ${\mathrm{EER}}^{\mathrm{GN}}$ is determined by the difference between the market-derived implied volatility and the estimated implied volatility absent arbitrage opportunities. Serving ${\mathrm{EER}}^{\mathrm{GN}}$ as the optimal predictor of ${\mathrm{RER}}^{\mathrm{GN}}$, we first find that ${\mathrm{EER}}^{\mathrm{GN}}$ positively predicts ${\mathrm{RER}}^{\mathrm{GN}}$. Second, the bottom-up ${\mathrm{EER}}^{\mathrm{GN}}$ complements the top-down ${\mathrm{EER}}^{\mathrm{GN}}$, enhancing the prediction of ${\mathrm{RER}}^{\mathrm{GN}}$. Third, the 10-1 portfolios formed on ${\mathrm{EER}}^{\mathrm{GN}}$ realize positive excess returns and sizeable Sharpe ratios in the future. The IPCA that employs information from different measures and terms generates superior performance.