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Economic significance of risk premiums in the S&P 500 option market
Author(s) -
Balyeat R. Brian
Publication year - 2002
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.10051
Subject(s) - economics , risk premium , volatility (finance) , valuation of options , crash , black–scholes model , profit (economics) , financial economics , econometrics , microeconomics , computer science , programming language
Option pricing is complicated by the theoretical existence of risk premiums. This article utilizes a testablemethodology to extract the pricing impact resulting from these risk premiums. First, option prices (based onthe full dynamics of the underlying) are computed under the assumption that these risk premiums are notpriced. The pricing methodology is independent of any particular option‐pricing model or distributionalassumptions 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. Forat‐the‐money, 13‐week S&P 500 options trading from 1989 until 1993, the effect of riskpremiums is statistically significant and averages slightly over 20% (in units of Black–Scholesimplied volatility). A simple delta‐hedging strategy is used to demonstrate the economic significanceof risk premiums, as the trading strategy provides enough profit to absorb a crash similar in magnitude to the1987 crash once every 6.20 years. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:1147–1178, 2002