Option‐Implied Ambiguity and Equity Return Predictability

ABSTRACT We propose a model‐guided option‐implied ambiguity measure to capture uncertainty regarding the return distribution of a risky asset underlying a set of options, and investigate its predictive power on the asset return. A representative investor's ambiguous beliefs or prior distributions on the underlying asset returns are extracted from the market prices of options, the expected volatility of which is then defined as the option‐implied ambiguity and is calculated in line with Brenner and Izhakian. Simulated paths of the calibrated models are utilized to compute all pertinent probability characteristics from a forward‐looking perspective. The empirical results with SSE 50 ETF options indicate that the proposed option‐implied ambiguity has strong predictive power for future returns of SSE 50 ETF. Out‐of‐sample tests also verify the significant predictive ability of the option‐implied ambiguity to the equity returns.