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Pricing of index options in incomplete markets

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  • Almeida, Caio
  • Freire, Gustavo

Abstract

We characterize a set of risk-neutral measures associated with a comprehensive class of risk averse investors. From this set, we show how to construct option price bounds and recover the implied γ: a parameter uniquely identifying the marginal investor pricing a given option. Empirically, we find that S&P 500 option prices are reconciled by heterogeneous marginal investors who differ in their assessment of tail risk. This heterogeneity is time-varying, decreases during financial crises, and provides novel insights into the skew patterns of index options. The recovered investors’ preferences related to compensation for downside risk help predict future market returns.

Suggested Citation

  • Almeida, Caio & Freire, Gustavo, 2022. "Pricing of index options in incomplete markets," Journal of Financial Economics, Elsevier, vol. 144(1), pages 174-205.
    • Handle: RePEc:eee:jfinec:v:144:y:2022:i:1:p:174-205
    DOI: 10.1016/j.jfineco.2021.05.041
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    More about this item

    Keywords

    Risk-neutral measure; Option pricing; Incomplete markets; Market segmentation; Return predictability;
    All these keywords.

    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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