A Bayesian Stochastic Discount Factor for the Cross-Section of Individual Equity Options

Niclas Käfer, Mathis Mörke, Florian Weigert, and Tobias Wiest

♦ We utilize Bayesian model averaging to estimate a stochastic discount factor (SDF) for single-stock options. A Bayesian model averaging SDF outperforms reduced-form benchmark models in-sample and out-of-sample in pricing option return anomalies and portfolios. We document that the SDF is dense in characteristics with the implied-realized volatility spread, option return momentum, and jump risk emerging as the most likely included factors. The option SDF exhibits a distinct business cycle pattern and aligns more closely with its counterpart in the stock market than in the bond market.

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