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Economic significance of risk premiums in the S&P 500 option market

✍ Scribed by R. Brian Balyeat

Publisher
John Wiley and Sons
Year
2002
Tongue
English
Weight
212 KB
Volume
22
Category
Article
ISSN
0270-7314

No coin nor oath required. For personal study only.

✦ Synopsis

Abstract

Option pricing is complicated by the theoretical existence of risk premiums. This article utilizes a testable
methodology to extract the pricing impact resulting from these risk premiums. First, option prices (based on
the full dynamics of the underlying) are computed under the assumption that these risk premiums are not
priced. The pricing methodology is independent of any particular option‐pricing model or distributional
assumptions on the return process for the underlying. The difference between the actual market prices and these
“no‐premium base case” prices reflects the effect of risk premiums. For
at‐the‐money, 13‐week S&P 500 options trading from 1989 until 1993, the effect of risk
premiums is statistically significant and averages slightly over 20% (in units of Black–Scholes
implied volatility). A simple delta‐hedging strategy is used to demonstrate the economic significance
of risk premiums, as the trading strategy provides enough profit to absorb a crash similar in magnitude to the
1987 crash once every 6.20 years. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:1147–1178, 2002

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