An Approach to Measure the Expectation of Generic Functions of the Market Return
59 Pages Posted: 11 Sep 2017
Date Written: August 24, 2017
This paper proposes an approach that associates the risk-neutral probability measure with option prices and then computes the expectation of quantities under the real world probability measure, exploiting the form of the stochastic discount factor. This approach deviates from foundational approaches that embrace assumptions about preferences and economic primitives to propose formulas for prices and risk premiums. Our method is analytically tractable, absolved of distributional assumptions, and we use the approach to elaborate on empirical questions regarding disaster probabilities, conditional return moments, and conditional return asymmetries.
Keywords: Expected market return; Disaster probabilities; Girsanov theorem; Equity index options
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