[We use forward-looking information from option prices to estimate option-implied correlations and to construct an option-implied predictor of factor betas. With our implied market betas, we find a monotonically increasing risk-return relation, not detectable with standard rolling-window betas, with the slope close to the market excess return. Our implied betas confirm a risk-return relation consistent with linear factor models because, when compared to other beta approaches: (i) they are better predictors of realized betas, and (ii) they exhibit smaller and less systematic prediction errors. The predictive power of our betas is not related to known relations between option-implied characteristics and returns.]

We use forward-looking information from option prices to estimate option-implied correlations and to construct an option-implied predictor of factor betas. With our implied market betas, we find a monotonically increasing risk-return relation, not detectable with standard rolling-window betas, with the slope close to the market excess return. Our implied betas confirm a risk-return relation consistent with linear factor models because, when compared to other beta approaches: (i) they are better predictors of realized betas, and (ii) they exhibit smaller and less systematic prediction errors. The predictive power of our betas is not related to known relations between option-implied characteristics and returns. The Author 2012. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please e-mail: [email protected]., Oxford University Press.

To understand the dynamics of investors’ asset demands, we develop a general-equilibrium model driven by a single latent variable: heterogeneity in investors’ confidence about mean endowment growth. The model predicts persistent heterogeneity in asset demands and concentrated portfolios. Consistent with the data, limited confidence reduces investors’ demand elasticities and makes stock prices excessively volatile—driven by latent demand rather than observable characteristics. The underlying economic mechanisms are driven primarily by investors’ desire to hedge changes in future beliefs instead of current disagreement. Finally, consistent with survey data, investors’ expectations correlate positively with past returns and negatively with future returns.

Strong regulatory actions are needed to combat climate change, but climate policy uncertainty makes it difficult for investors to quantify the impact of future climate regulation. We show that such uncertainty is priced in the option market. The cost of option protection against downside tail risks is larger for firms with more carbon-intense business models. For carbon-intense firms, the cost of protection against downside tail risk is magnified at times when the public’s attention to climate change spikes, and it decreased after the election of climate change skeptic President Trump.