Non-Linear CAPM: Evidence From In-The-Money Options Trading
39 Pages Posted: 21 Oct 2022
Date Written: October 10, 2022
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). This result suggests that public investors are the marginal investors in the options market. Finally, we show that the 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
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