M. Buchner and B. Kelly: A Factor Model for Option Returns

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.