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The Factor Structure in Equity Options

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Author Info

  • Peter Christoffersen

    ()
    (University of Toronto and CREATES)

  • Mathieu Fournier

    ()
    (Rotman School of Management)

  • Kris Jacobs

    ()
    (University of Houston)

Abstract

Principal component analysis of equity options on Dow-Jones firms reveals a strong factor structure. The first principal component explains 77% of the variation in the equity volatility level, 77% of the variation in the equity option skew, and 60% of the implied volatility term structure across equities. Furthermore, the first principal component has a 92% correlation with S&P500 index option volatility, a 64% correlation with the index option skew, and a 80% correlation with the index option term structure. We develop an equity option valuation model that captures this factor structure. The model allows for stochastic volatility in the market return and also in the idiosyncratic part of firm returns. The model predicts that firms with higher betas have higher implied volatilities, and steeper moneyness and term structure slopes. We provide a tractable approach for estimating the model on a large set of index and equity option data on which the model provides a good fit. The equity option data support the cross-sectional implications of the estimated model.

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Bibliographic Info

Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2013-47.

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Length: 58
Date of creation: 06 2013
Date of revision:
Handle: RePEc:aah:create:2013-47

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Web page: http://www.econ.au.dk/afn/

Related research

Keywords: factor models; equity options; implied volatility; option-implied beta;

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References

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