Isolating the disaster risk premium with equity options

The US equity risk premium is approximated with a mean unhedged equity return. I utilize out-of-the-money put options to obtain a hedged equity return, which allows me to quantify the disaster risk premium as the difference between the means of unhedged and hedged equity returns. I demonstrate that a substantial fraction of the U.S. equity risk premium over the period from 1996 to 2016 is attributed to disasters defined as stock price depreciations below a pre-specified strike price. Employing alternative hedging schemes increases the contribution of disasters to the equity risk premium.     

Dynamic, nonparametric hedging of European style contingent claims using canonical valuation

The canonical valuation, proposed by Stutzer [1996. Journal of Finance 51, 1633–1652], is a nonparametric option pricing approach for valuing European-style contingent claims. This paper derives risk-neutral dynamic hedge formulae for European call and put options under canonical valuation that obey put–call parity. Further, the paper documents the error-metrics of the canonical hedge ratio and analyzes the effectiveness of discrete dynamic hedging in a stochastic volatility environment. The results suggest that the nonparametric hedge formula generates hedges that are substantially unbiased and is capable of producing hedging outcomes that are superior to those produced by Black and Scholes [1973. Journal of Political Economy 81, 637–654] delta hedging.     

An experimental study on real-options strategies

We conduct a laboratory experiment to study whether people intuitively use real-option strategies in a dynamic investment setting. The participants were asked to play as an oil manager and make production decisions in response to a simulated mean-reverting oil price. Using cluster analysis, participants can be classified into four groups, which we label ‘mean-reverting’, ‘Brownian motion real-option’, ‘Brownian motion myopic real-option’, and ‘ambiguous’. We find two behavioral biases in the strategies of our participants: ignoring the mean-reverting process, and myopic behavior. Both lead to too frequent switches when compared with the theoretical benchmark. We also find that the last group behaved as if they have learned to incorporate the true underlying process into their decisions, and improved their decisions during the later stage.     

Psychology,Stock/FX Trading and Option Prices

The financial crisis of 2008 had many putative causes where psychology was an important driver for human decisions. However, quantitative financial models have no “knobs” to dial psychology parameters, and so arguably cannot possibly cope with financial crises. Here we take a first step by considering how a particular aspect of psychology can influence an underlying security and subsequent option prices, in a quantitative model. We investigate how psychological regret and fear impact trading selling behavior and induces changes in underlying security prices. We then consider the resulting changes in option prices with empirical evidence.     

Analytic approximation formulae for European crack spread options

In this paper, we investigate and compare the pricing of European crack spread call options under different underlying models. New proposed univariate and explicit constant elasticity of variance (CEV) models are assumed and new analytic approximation formulae in the form of asymptotic expansions are derived. As well we derive an analytic approximation formula based on an explicit version of two correlated Schwartz models. In order to compare the performance of our new formulae with the performance of current popular formulae, we calibrate market prices of short tenor heating oil crack spread call options (traded on the New York Mercantile Exchange) and empirically test their performances. Results from the analysis show that our univariate-based CEV formulae outperforms known univariate formulae in capturing market prices. Overall, however we found the explicit approach to be superior to the univariate approach and in particular our new explicit-based formulae performed best in capturing market prices for options with short tenor.     

Optimal multi-period consumption and investment with short-sale constraints

This article examines agents’ consumption-investment problem in a multi-period pure exchange economy where agents are constrained with the short-sale of state-dependent risky contingent claims. In equilibrum, agents hold options written on aggregate consumption in their optimal portfolios. Furthermore, under the specific case of quadratic utility, the optimal risk-sharing rule derived for the pricing agent leads to a multifactor conditional consumption-based capital asset pricing model (CCAPM), where excess option returns appear as factors.     

Consistent Variance Curve Models

We introduce a general approach to model a joint market of stock price and a term structure of variance swaps in an HJM-type framework. In such a model, strongly volatility-dependent contracts can be priced and risk-managed in terms of the observed stock and variance swap prices. To this end, we introduce equity forward variance term structure models and derive the respective HJM-type arbitrage conditions. We then discuss finite-dimensional Markovian representations of the fixed time-to-maturity forward variance swap curve and derive consistency results for both the standard case and for variance curves with values in a Hilbert space. For the latter, our representation also ensures non-negativity of the process. We then give a few examples of such variance curve functionals and briefly discuss completeness and hedging in such models. As a further application, we show that the speed of mean reversion in some standard stochastic volatility models should be kept constant when the model is recalibrated.     

Hedging the smirk

This article presents a simple “model-free” method for inferring deltas and gammas from implicit volatility patterns. An illustration indicates that Black–Scholes deltas and gammas are substantially biased in the presence of the sort of smirks and smiles evident in stock index options.     

Assessing central bank credibility during the ERM crises: Comparing option and spot market-based forecasts

Financial markets embed expectations of central bank policy into asset prices. This paper compares two approaches that extract a probability density of market beliefs. The first is a simulated moments estimator for option volatilities described in [Mizrach, B., 2002. When Did the Smart Money in Enron Lose Its’ Smirk? Rutgers University Working Paper #2002-24]; the second is a new approach developed by [Haas, M., Mittnik, S., Paolella, M.S., 2004a. Mixed normal conditional heteroskedasticity, J. Financial Econ. 2, 211–250] for fat-tailed conditionally heteroskedastic time series. In an application to the 1992–1993 European Exchange Rate Mechanism crises, we find that both the options and the underlying exchange rates provide useful information for policy makers.     

Folding Arguments: A Method for Representing Conflicting Views of a Conflict

This article presents a method for representing social conflict under disagreements over its representation, with the view that the resolution of such disagreements often affects the resolution of the conflict itself. The Argumentative Analysis of Options (AAO) method proposed here extends Howard's Analysis of Options method for conflict analysis. The AAO method highlights the role of policy discourse in resolving the disagreed representation, and models arguments made in these social processes. In this method, people's arguments are folded into a "strategic map" of a conflict, using a new coding system based on modal logic. The method is designed to be incorporated into group support systems (GSS) as a non-exclusive, non-specialist communication medium for both principal players and grassroots people. An experimental study is reported in which use of a prototype of GSS with the AAO method resulted in an assembly of rational and structured arguments in an attempt to resolve a hypothetical conflict. An evaluation by users of the prototype GSS suggested that it was less simple and more difficult to use, but richer than a more traditional electronic mail system. Design implications and potential pitfalls of this approach to GSS are discussed based on the results of the experimental study.