Modeling Conditional Factor Risk Premia Implied by Index Option Returns

82 Pages Posted: 2 Sep 2021 Last revised: 18 Oct 2021

See all articles by Mathieu Fournier

Mathieu Fournier

HEC Montreal

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Piotr Orłowski

HEC Montréal

Date Written: July 26, 2021

Abstract

We propose a novel factor model for option returns. Option exposures are estimated nonparametrically and factor risk premia can vary nonlinearly with states. The model is estimated using regressions, with minimal assumptions on factor and option return dynamics. Using index options, we characterize the conditional risk premia for the market return, market variance, and tail and intermediary risk factors. All average risk premia have the expected sign and meaningful magnitudes. Market and variance risk premia display pronounced time-variation, spike during crises, and always have the expected sign. Combined, market return and variance explain more than 90% of option return variation.

Keywords: Option Returns, Factor Models, Option-Implied Factor Risk Premia, Time-Varying Exposures, Machine Learning

JEL Classification: G10, G12, G13

Suggested Citation

Fournier, Mathieu and Jacobs, Kris and Orłowski, Piotr, Modeling Conditional Factor Risk Premia Implied by Index Option Returns (July 26, 2021). Available at SSRN: https://ssrn.com/abstract=3893807 or http://dx.doi.org/10.2139/ssrn.3893807

Mathieu Fournier

HEC Montreal ( email )

3000, Chemin de la Côte-Sainte-Catherine
Montreal, Quebec H2X 2L3 H3T 2A7
Canada

Kris Jacobs

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Piotr Orłowski (Contact Author)

HEC Montréal ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada

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