Irreducible Risks: Fallacy of Risk-Neutral Approach to Options

25 Pages Posted: 7 Jan 2021 Last revised: 15 Jan 2021

See all articles by Margaret Sundberg

Margaret Sundberg

Volaris Capital Management

Jake Freeman

Volaris Capital Management; University of Southern California

Vivek Kapoor

Volaris Capital Management

Date Written: January 6, 2021

Abstract

This paper compares two approaches to options: (1) Risk-Aware Approach, and (2) Risk-Neutral Approach. The risk-aware approach requires a probabilistic specification of the underlying’s returns, addressing higher than second moments, as hedging errors are singularly dependent on the excess kurtosis of the returns. Becoming risk-aware requires explicitly assessing hedge slippage of a hedging strategy to attempt option replication. In contrast, the risk-neutral tautology sets the option price equal to an expectation of option payoff under a risk-neutral probability that is inferred from option prices and under which the asset does not expect to accrete/deplete wealth. In the presence of irreducible risks, while a risk-neutral probability measure may be fit to observed option prices, it does not inform about the partitioning between expected attempted replication costs and compensation for irreducible risks. In segmented option markets with distinct risk premiums such a risk-neutral probability measure fails to exist.

Keywords: options, optimal hedging, irreducible risks, risk premium, risk-neutral probability

JEL Classification: G11, G12, G14

Suggested Citation

Sundberg, Margaret and Freeman, Jake and Kapoor, Vivek, Irreducible Risks: Fallacy of Risk-Neutral Approach to Options (January 6, 2021). Available at SSRN: https://ssrn.com/abstract=3761304

Margaret Sundberg

Volaris Capital Management ( email )

343 Millburn Ave
Suite 304
Millburn, NJ 07041
United States

HOME PAGE: http://www.volariscapital.com

Jake Freeman

Volaris Capital Management ( email )

343 Millburn Ave
Suite 304
Millburn, NJ 07041
United States
973-908-3347 (Phone)

University of Southern California ( email )

Los Angeles, CA
United States

Vivek Kapoor (Contact Author)

Volaris Capital Management ( email )

343 Millburn Ave
Suite 304
Millburn, NJ 07041
United States
973-985-7128 (Phone)

HOME PAGE: http://volariscapital.com

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