The economic measure of riskiness, forward-looking information and predictability of return rate

How to accurately forecast risk is a practical problem faced by investors and an important theoretical issue in the field of financial research. In the past, risk measurement using historical data often lacked foresight, leading to poor practical performance of risk management tools. In order to improve the foresight and accuracy of risk forecast, this paper employs the cashflow replication method to extract implied economic risk (IER) that is proposed by Nobel laureate Aumann and others from the SSE 50ETF option prices, and predicts future returns based on IER. It is found that: ① Chinese options market implies the future risk of the stock market, and the IER assumes a similar function to the fear index VIX in America, that is, the IER decreases when the market is strong, and vice versa. ② The in-sample tests show that the IER can negatively predict the future return of the underlying asset significantly since it contains the risk-neutral moment information of the return rate. ③ The forecast tests indicate that the IER delivers statistically significant out-of-sample R2 relative to the historical average return and the “backward-looking” economic risk indices, therefore asset allocation strategies with IER can get economically significant gains than competitive predictors. The conclusions of this paper have important policy meaning and practical implications. © 2024 Systems Engineering Society of China. All rights reserved.