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The Factor Structure in Equity Options

Author

Listed:
  • 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.

Suggested Citation

  • Peter Christoffersen & Mathieu Fournier & Kris Jacobs, 2013. "The Factor Structure in Equity Options," CREATES Research Papers 2013-47, Department of Economics and Business Economics, Aarhus University.
  • Handle: RePEc:aah:create:2013-47
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    File URL: ftp://ftp.econ.au.dk/creates/rp/13/rp13_47.pdf
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    References listed on IDEAS

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    Cited by:

    1. Michel van der Wel & Sait R. Ozturk & Dick van Dijk, 2016. "Dynamic Factor Models for the Volatility Surface," Advances in Econometrics,in: Dynamic Factor Models, volume 35, pages 127-174 Emerald Publishing Ltd.
    2. Vogt, Erik, 2014. "Option-implied term structures," Staff Reports 706, Federal Reserve Bank of New York, revised 01 Jan 2016.
    3. repec:eee:ecmode:v:64:y:2017:i:c:p:295-301 is not listed on IDEAS

    More about this item

    Keywords

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

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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