A Factor Model for Stock Returns Based on Option Prices
68 Pages Posted: 1 Dec 2019 Last revised: 13 May 2022
Date Written: March 31, 2022
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
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