A factor model for option returns

Matthias Büchner and Bryan Kelly

Journal of Financial Economics, 2022, vol. 143, issue 3, 1140-1161

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.

Keywords: Option return; Factor model; Return predictability; IPCA (search for similar items in EconPapers)
JEL-codes: G11 G12 G13 (search for similar items in EconPapers)
Date: 2022
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Citations: View citations in EconPapers (12)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:jfinec:v:143:y:2022:i:3:p:1140-1161

DOI: 10.1016/j.jfineco.2021.12.007

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