The Relation between information in option prices and short term market return

Abstract: Abstract The purpose of this thesis is to analyze if implied volatility and the implied risk neutral density function can predict short term market return of the Swedish OMX-index. To study the relation between information in option prices and short term market return I perform and OLS-regression with the market return as dependent variable. Implied volatility and the various moments of the implied density function are used as independent variables. Data from the Swedish OMX-index at the Stockholm Stock Exchange for the period September through December 2002 is used in the study. The study shows that high implied volatility of at the money options predicts a positive return on the OMX-index in the next three days. The prediction power is also strong for the third moment of the implied density function i.e. skewness. Key words: option prices, implied volatility, short term return, mean reversion, implied risk neutral density function