Option Prices Sustained by Risk‐Preferences*
Year: 2005
Type: article
Abstract: This paper investigates the preference and distribution restrictions that underlie explicit risk-neutral option valuation equations. It establishes new sufficient conditions in terms of utility functions and joint distributions of assets ’ payoffs and state variables for these models to hold in equilibrium economies where markets are dynamically incomplete. For example, the paper derives the Black-Scholes model assuming that there is a representative agent with an exponential utility function of wealth characterized by constant absolute risk aversion (CARA) preferences. Aggregate wealth and the underlying stock price are bivariate normal-lognormal distributed. Both the marginal and the conditional distributions of wealth play relevant roles in obtaining the pricing kernel implicit in the model. This result is interesting because it shows that there is not a straightforward link between the Black-Scholes model and constant proportional risk aversion (CPRA) preferences. The paper One of the most important frameworks in financial economics is the Black-Scholes (1973) model for the pricing of options. In Merton’s opinion (1973) the model is significant because “an exact formula for an asset price, based on observable variables only is a rare finding...the
Source: The Journal of Business
DOI: 10.1086/431439
Author: António Câmara
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: green
OpenAlex ID: W2141626545