A Factor Model for Stock Returns Based on Option Prices

68 Pages Posted: 1 Dec 2019 Last revised: 13 May 2022

See all articles by Turan G. Bali

Turan G. Bali

Georgetown University - McDonough School of Business

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management

Scott Murray

Georgia State University

Date Written: March 31, 2022

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

Suggested Citation

Bali, Turan G. and Chabi-Yo, Fousseni and Murray, Scott, A Factor Model for Stock Returns Based on Option Prices (March 31, 2022). Available at SSRN: https://ssrn.com/abstract=3487947 or http://dx.doi.org/10.2139/ssrn.3487947

Turan G. Bali

Georgetown University - McDonough School of Business ( email )

3700 O Street, NW
Washington, DC 20057
United States
(202) 687-5388 (Phone)
(202) 687-4031 (Fax)

HOME PAGE: https://sites.google.com/a/georgetown.edu/turan-bali

Fousseni Chabi-Yo

University of Massachusetts Amherst - Isenberg School of Management ( email )

Amherst, MA 01003-4910
United States

Scott Murray (Contact Author)

Georgia State University ( email )

35 Broad Street
Atlanta, GA 30303-3083
United States

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