Macroeconomic factors and index option returns

•This study investigates whether macroeconomic factors are priced in the cross-section of index option returns.•Macroeconomic factors are extracted from a large panel of 132 economic activity indicators using dynamic factor analysis.•The risk premia on inflation, term spread, industrial production, and housing factors are significant.•Business sales is the most useful conditioning factor for the CAPM.•These significant factors provide information that is not fully captured by Fama and French's (2015) investment and profitability factors.

This study empirically investigates whether macroeconomic factors are priced in the cross-section of index option returns. Macroeconomic factors are extracted from a large panel of 132 economic activity indicators using dynamic factor analysis. The empirical analysis employs linear factor methodology with a factor structure including market return and macroeconomic factors. The results show that the risk premia on inflation, term spread, industrial production, and housing factors are significant. Further, business sales is a useful conditioning factor that drives variation in market betas. These extracted macroeconomic factors provide information that is not fully captured by Fama and French's (2015) investment and profitability factors.