Market Risk Premium Expectation : Combining Option Theory with Traditional Predictors

The market risk premium is central in finance, and has been analyzed by numerous studies in the time-series predictability literature and by growing studies in the options literature. In this paper, we provide a novel link between the two literatures. Theoretically, we derive a lower bound on the equity risk premium in terms of option prices and state variables. Empirically, we show that combining information from both options and investor sentiment significantly improves the out-of-sample predictability of the market risk premium versus using either type of information alone and adding an economic upper bound raises predictability further