State Prices of Conditional Quantiles : New Evidence on Time-Varying Expected Returns

We develop statistics to represent the option implied stochastic discount factor for S&P 500 returns between 1990 and 2008. Our statistics, which we call State Prices of Conditional Quantiles (SPOCQ), estimate the market's willingness to pay for insurance against outcomes in various quantiles of the return distribution. We demonstrate that the market applied deep discounts to large negative returns during the recessionary periods of 1990-91, 1998-2003, and 2008 and minimal discounts in the boom periods of 1995-96 and 2006-07. We show how SPOCQ relates directly to expected returns. SPOCQ has strong predictive power for S&P 500 returns at the two-year horizon. It generates an R-squared of 0.27 for two-year returns and implies an annualized standard deviation of two-year expected returns equal to 7%. The predictive power of SPOCQ can only be partially explained by the dividend yield and the consumption wealth ratio (CAY) because SPOCQ is more closely tied to the business cycle than are these variables