A Factor Model for Option Returns
52 Pages Posted: 5 Sep 2019 Last revised: 20 Nov 2019
Date Written: August 19, 2019
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 tradeoff in other asset classes. Instrumented principal components analysis (IPCA) solves this problem by tracking contracts in terms of their pricing-relevant characteristics. We recover the latent common risk factors in option returns and the time-varying loadings of individual options on these factors. Five latent factors explain more than 90% of the variation in a panel of monthly S&P 500 option returns from 1996 to 2017. The factors we estimate are interpretable as jump, volatility, and term structure spread risks.
Keywords: Option Return; Factor Model; Return Predictability; IPCA
JEL Classification: G02, G12, G13
Suggested Citation: Suggested Citation