A Factor Model for Stock Returns Based on Option Prices

Abstract

Option prices reflect investors' assessment of future risk and risk premia, and therefore contain information about expected stock returns. We show theoretically that expected stock returns are a function of the difference between risk-neutral and physical variance, and the stock borrow fee. Based on this theory, we construct an empirical factor model that includes factors formed by sorting stocks on option-based variables. We find that the model has a higher tangent portfolio Sharpe ratio than extant factor models and outperforms such models at explaining the performance of portfolios formed by sorting on many option-based and traditional asset pricing variables.

Keywords: Factor model, option prices, cross section of stock returns

JEL Classification: G11, G12, G13