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General Equilibrium Pricing of Options on the Market Portfolio with Discontinuous Returns

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Author Info
Naik, Vasanttilak
Lee, Moon
Abstract

When the price process for a long-lived asset is of a mixed jump-diffusion type, pricing of options on that asset by arbitrage is not possible if trading is allowed only in the underlaying asset and a risk-less bond. Using a general equilibrium framework, we derive and analyze option prices when the underlying asset is the market portfolio with discontinuous returns. The premium for the risk of jumps and the diffusion risks forms a significant part of the prices of the options. In this economy, an attempted replication of call and put options by the Black-Scholes type of trading strategies may require substantial infusion of funds when jumps occur. We study the cost and risk implications of such dynamic hedging plans. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

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Article provided by Oxford University Press for Society for Financial Studies in its journal Review of Financial Studies.

Volume (Year): 3 (1990)
Issue (Month): 4 ()
Pages: 493-521
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Handle: RePEc:oup:rfinst:v:3:y:1990:i:4:p:493-521

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  2. Jin-Chuan Duan & Peter Ritchken & Zhiqiang Sun, 2006. "Jump starting GARCH: pricing and hedging options with jumps in returns and volatilities," Working Paper 0619, Federal Reserve Bank of Cleveland. [Downloadable!]
  3. J. David Cummins & Christopher M. Lewis & Richard D. Phillips, 1998. "Pricing Excess-of-loss Reinsurance Contracts Against Catastrophic Loss," Center for Financial Institutions Working Papers 98-09, Wharton School Center for Financial Institutions, University of Pennsylvania. [Downloadable!]
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  4. Torben G. Andersen & Luca Benzoni & Jesper Lund, 2001. "An Empirical Investigation of Continuous-Time Equity Return Models," NBER Working Papers 8510, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Laurent E. Calvet & Adlai J. Fisher, 2006. "Multifrequency Jump-Diffusions: An Equilibrium Approach," NBER Working Papers 12797, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. David Backus & Mikhail Chernov & Ian Martin, 2009. "Disasters implied by equity index options," NBER Working Papers 15240, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  7. Frank Milne & Dilip Madan, 1991. "Option Pricing With V. G. Martingale Components," Working Papers 1159, Queen's University, Department of Economics. [Downloadable!]
  8. Alfredo Ibáñez, 2008. "The cross-section of average delta-hedge option returns under stochastic volatility," Review of Derivatives Research, Springer, vol. 11(3), pages 205-244, October. [Downloadable!] (restricted)
  9. Ciprian Necula, 2008. "A Two-Country Discontinuous General Equilibrium Model," Advances in Economic and Financial Research - DOFIN Working Paper Series 23, Bucharest University of Economics, Center for Advanced Research in Finance and Banking - CARFIB. [Downloadable!]
  10. Ravi Bansal & Ivan Shaliastovich, 2009. "Learning and Asset-Price Jumps," NBER Working Papers 14814, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  11. Richards, Timothy J. & Nganje, William E. & Acharya, Ram, 2008. "Hysterisis in Food Safety Investments," 110th Seminar, February 18-22, 2008, Innsbruck-Igls, Austria 49888, European Association of Agricultural Economists. [Downloadable!]
  12. Liu, Jun & Pan, Jun, 2003. "Dynamic Derivative Strategies," Working papers 4334-02, Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
  13. Patrick K. Asea & Mthuli Ncube, 1997. "Heterogeneous Information Arrival and Option Pricing," NBER Working Papers 5950, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  14. René Garcia & Éric Renault, 1998. "Risk Aversion, Intertemporal Substitution, and Option Pricing," CIRANO Working Papers 98s-02, CIRANO. [Downloadable!]
  15. Patrick Asea & Mthuli Nube, 1997. "Heterogeneous Information Arrival and Option Pricing," UCLA Economics Working Papers 763, UCLA Department of Economics. [Downloadable!]
  16. Ren-Raw Chen & Oded Palmon, 2005. "A Non-Parametric Option Pricing Model: Theory and Empirical Evidence," Review of Quantitative Finance and Accounting, Springer, vol. 24(2), pages 115-134, January. [Downloadable!] (restricted)
  17. Jessica Wachter, 2008. "Can Time-Varying Risk of Rare Disasters Explain Aggregate Stock Market Volatility?," NBER Working Papers 14386, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  18. George J. Jiang & Pieter J. van der Sluis, 1998. "Pricing Stock Options under Stochastic Volatility and Stochastic Interest Rates with Efficient Method of Moments Estimation," Tinbergen Institute Discussion Papers 98-067/4, Tinbergen Institute. [Downloadable!]
  19. René Garcia & Richard Luger & Éric Renault, 2001. "Asymmetric Smiles, Leverage Effects and Structural Parameters," CIRANO Working Papers 2001s-01, CIRANO. [Downloadable!]
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  20. Francis Longstaff & Monika Piazzesi, 2003. "Corporate Earnings and the Equity Premium," NBER Working Papers 10054, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  21. Richards, Timothy J. & Manfredo, Mark R. & Sanders, Dwight R., 2002. "Weather Derivatives: Managing Risk With Market-Based Instruments," 2002 Conference, April 22-23, 2002, St. Louis, Missouri 19074, NCR-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management. [Downloadable!]
  22. C. Mancini, 2002. "The European options hedge perfectly in a Poisson-Gaussian stock market model," Applied Mathematical Finance, Taylor and Francis Journals, vol. 9(2), pages 87-102, June. [Downloadable!] (restricted)
  23. Peter Christoffersen & Kris Jacobs & Chayawat Ornthanalai, 2009. "Exploring Time-Varying Jump Intensities: Evidence from S&P500 Returns and Options," CIRANO Working Papers 2009s-34, CIRANO. [Downloadable!]
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