Abstract

http://ssrn.com/abstract=1297801
 


 



Why are Options Expensive?


Marti G. Subrahmanyam


New York University - Stern School of Business

Günter Franke


affiliation not provided to SSRN

Richard C. Stapleton


University of Strathclyde - Department of Accounting and Finance

February 1998

NYU Working Paper No. FIN-98-065

Abstract:     
Many valuation models in financial economics are developed using the pricing kernel approach to adjust for risk through the equivalent martingale representation. Often it is assumed, explicitly or implicitly, that the pricing kernel exhibits constant elasticity with respect to the price of the market portfolio. In a representative agent economy this would be close to assuming that the representative agent has constant proportional risk aversion. The elasticity of the pricing kernel has also implications for the pricing of options. This paper shows, first, that given the forward price of the market portfolio, all European options would have higher prices if the elasticity of the pricing kernel was declining instead of constant. Moreover, a volatility smile-effect is generated. Second, the paper shows that the standard geometric Brownian motion underlying the Black/Scholes model requires constant elasticity of the pricing kernel . Third, if the price of the market portfolio at the expiration date of an option is lognormally distributed, then declining elasticity of the pricing kernel implies a stochastic process which is characterized by higher volatility and negative autocorrelation. Thus, declining elasticity of the pricing kernel can explain several empirical findings.

Number of Pages in PDF File: 38

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Date posted: November 11, 2008  

Suggested Citation

Subrahmanyam, Marti G. and Franke, Günter and Stapleton, Richard C., Why are Options Expensive? (February 1998). NYU Working Paper No. FIN-98-065. Available at SSRN: http://ssrn.com/abstract=1297801

Contact Information

Marti G. Subrahmanyam (Contact Author)
New York University - Stern School of Business ( email )
Stern School of Business,
44 West 4th Street, Suite 9-68
New York, NY 10012-1126
United States
212-998-0348 (Phone)
212-995-4233 (Fax)
Günter Franke
affiliation not provided to SSRN
No Address Available
Richard C. Stapleton
University of Strathclyde - Department of Accounting and Finance ( email )
Curran Building
100 Cathedral Street
Glasgow G4 0LN
United Kingdom
+44 1524 381 172 (Phone)
+44 1524 846874 (Fax)
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