A Factor Model for Option Returns

62 Pages Posted: 5 Sep 2019 Last revised: 6 Oct 2021

See all articles by Matthias Büchner

Matthias Büchner

University of Cambridge - Centre for Endowment Asset Management, Cambridge Judge Business School

Bryan T. Kelly

Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: September 28, 2021

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

JEL Classification: G02, G12, G13

Suggested Citation

Büchner, Matthias and Kelly, Bryan T., A Factor Model for Option Returns (September 28, 2021). Journal of Financial Economics (JFE), Forthcoming, Available at SSRN: https://ssrn.com/abstract=3444232 or http://dx.doi.org/10.2139/ssrn.3444232

Matthias Büchner (Contact Author)

University of Cambridge - Centre for Endowment Asset Management, Cambridge Judge Business School ( email )

Cambridge
United Kingdom

Bryan T. Kelly

Yale SOM ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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