August 19, 2019
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. Instrumented 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.