A Factor Model For Option Returns

Matthias Buechner and Bryan T. Kelly

No 29369, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Due to their short lifespans and migrating moneyness, options are notoriously difficult to study with the factor models commonly used to analyze the risk-return trade-off in other asset classes. Instrumented principal components analysis solves this problem by tracking contracts in terms of their pricing-relevant characteristics via time-varying latent factor loadings. We find that a model with three latent factors prices the cross-section of option returns and explains more than 85% of the variation in a panel of monthly S&P 500 option returns from 1996 to 2017. In particular, we show that the IPCA factors can be rationalized via an economically plausible three-factor model consisting of a level, slope and skew factor. Finally, out-of-sample trading strategies based on insights from the IPCA model have significant alpha over previously studied option strategies.

JEL-codes: G1 G12 (search for similar items in EconPapers)
Date: 2021-10
New Economics Papers: this item is included in nep-cwa and nep-fmk
Note: AP
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Published as Matthias Büchner & Bryan Kelly, 2022. "A factor model for option returns," Journal of Financial Economics, vol 143(3), pages 1140-1161.

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