Non-Linear CAPM: Evidence From In-The-Money Options Trading

Abstract

We investigate the cross-section of option returns using a model-free approach, by constructing a stochastic discount factor (SDF) that features minimal variance and accounts for frictions. We find that incorporating transaction costs in the form of bid-ask spreads is essential in order to obtain realistic positions in the optimal trading strategy, that mainly invests in in-the-money call options. Empirically, we show that the out-of-sample pricing errors of the constrained SDF are 90% lower than the ones implied by the benchmark unconstrained SDF. Our findings document a strong link between the optimal portfolio accounting for transaction costs and the option positions held by public investors (non-intermediaries). Finally, we show that trading activity of customers in in-the-money call options has significant explanatory power for the cross-section of individual equity option returns.

Keywords: Minimum variance SDF, Index Options, Public Investors

JEL Classification: G01, G13, G14, G20