A Factor Model for Option Returns

53 Pages Posted: 5 Sep 2019 Last revised: 8 Sep 2020

See all articles by Matthias Büchner

Matthias Büchner

University of Cambridge - Centre for Endowment Asset Management, Cambridge Judge Business School

Bryan T. Kelly

Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)

Date Written: August 19, 2019

Abstract

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 tradeoff in other asset classes. In-trumented principal components analysis (IPCA) solves this problem by tracking contracts in terms of their pricing-relevant characteristics. We recover the latent common risk factors in option returns and the time-varying loadings of individual options on these factors. Five latent factors explain more than 90% of the variation in a panel of monthly S&P 500 option returns from 1996 to 2017. The factors we estimate are interpretable as jump, volatility, and term structure spread risks.

Keywords: Option Return; Factor Model; Return Predictability; IPCA

JEL Classification: G02, G12, G13

Suggested Citation

Büchner, Matthias and Kelly, Bryan T., A Factor Model for Option Returns (August 19, 2019). Available at SSRN: https://ssrn.com/abstract=3444232 or http://dx.doi.org/10.2139/ssrn.3444232

Matthias Büchner (Contact Author)

University of Cambridge - Centre for Endowment Asset Management, Cambridge Judge Business School ( email )

Cambridge
United Kingdom

Bryan T. Kelly

Yale SOM ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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