Estimating the Implicit Market Model from Option Prices

The main novelty of this paper is to develop a preference-free option pricing formula which involves index return volatility and the alpha, beta, and firm-specific risk of underlying stock returns by formulating option payoffs with the market model in the multivariate risk-neutral valuation framework. We thus estimate the option implicit market model, namely the forward-looking alpha, beta, and firm-specific risk, by calibrating equity and index option prices. Empirical illustration indicates that our model calibrates equity options accurately, the CAPM holds with option-implied estimates, and option-implied estimates are more effective than regression-based historical estimates in predicting alpha, beta, firm-specific risk, and stock returns (conditional on the contemporaneous index returns) in a future horizon.