Risk Neutral Probabilities and Option Bounds: A Geometric Approach
Lancaster University - Department of Accounting and Finance
February 28, 2005
Lancaster University Management School Working Paper No. 2004/052, EFA 2005 Moscow Meetings Paper
In this paper we first present a geometric approach to option bounds. We show that if two risk neutral probability density functions intersect for certain number of times, then comparing the fatness of their tails we can tell which of them gives higher option prices. Thus we can derive option bounds by identifying the risk neutral probability density function which intersects all admissible ones for certain number of times. Applying this approach we tighten the first order stochastic dominance option bounds when the maximum value of the risk neutral density is known. The method present in this paper has wide applications in option pricing problems.
Number of Pages in PDF File: 58
Keywords: Option bounds, option pricing, risk neutral density, first order stochastic dominance
JEL Classification: G13working papers series
Date posted: March 6, 2005
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