Forecasting Stock Returns Using Option-Implied State Prices*

Options prices embed the risk preferences that determine expected returns in asset pricing models. Therefore, functions of options prices should predict returns. In this paper, we show that the State Prices of Conditional Quantiles (SPOCQ)-functions of options prices introduced in Metaxoglou and Smith (2016)-exhibit strong predictive ability for the U.S. equity premium. These SPOCQ series provide estimates of the market's willingness to pay for insurance against outcomes in various quantiles of the return distribution. They also relate to expected returns in prominent asset pricing models. Our SPOCQ series that captures relative risk aversion exhibits strong predictive ability for S&P 500 returns at horizons between 6 and 18 months, both in the full sample, 1990-2012, and out of sample. Our SPOCQ series that captures volatility aversion, however, exhibits no predictive ability due to the lack of skewness in the return distribution for the horizons considered.