A Factor Model For Option Returns / Matthias Buechner, Bryan T. Kelly.

Format:

Book

Author/Creator:

Buechner, Matthias.

Contributor:

National Bureau of Economic Research.

Kelly, Bryan T.

Series:

Working Paper Series (National Bureau of Economic Research) no. w29369.

NBER working paper series no. w29369

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2021.

Summary:

Due to their short lifespans and migrating moneyness, options are notoriously difficult to study with the factor models commonly used to analyze the risk-return trade-off in other asset classes. Instrumented principal components analysis solves this problem by tracking contracts in terms of their pricing-relevant characteristics via time-varying latent factor loadings. We find that a model with three latent factors prices the cross-section of option returns and explains more than 85% of the variation in a panel of monthly S&P 500 option returns from 1996 to 2017. In particular, we show that the IPCA factors can be rationalized via an economically plausible three-factor model consisting of a level, slope and skew factor. Finally, out-of-sample trading strategies based on insights from the IPCA model have significant alpha over previously studied option strategies.

Notes:

Print version record

October 2021.