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Consumption and Portfolio Choice with Option-Implied State Prices

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  • Yacine Aït-Sahalia
  • Michael W. Brandt

Abstract

We propose an empirical implementation of the consumption-investment problem using the martingale representation alternative to dynamic programming. Our method is based on the direct observation of state prices from options data. This greatly simplifies the investor's task of specifying the investment opportunity set and inherits the computational convenience of the martingale representation. Our method also makes explicit the economic trade-off between exploiting differences in state prices and probabilities, which generate variation in consumption, and the consumption smoothing induced by risk aversion. Using options-implied information, we find quantitatively different optimal consumption and portfolio policies than those implied by standard return dynamics.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13854.

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Date of creation: Mar 2008
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Handle: RePEc:nbr:nberwo:13854

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  1. Breeden, Douglas T & Litzenberger, Robert H, 1978. "Prices of State-contingent Claims Implicit in Option Prices," The Journal of Business, University of Chicago Press, vol. 51(4), pages 621-51, October.
  2. Banz, Rolf W & Miller, Merton H, 1978. "Prices for State-contingent Claims: Some Estimates and Applications," The Journal of Business, University of Chicago Press, vol. 51(4), pages 653-72, October.
  3. Ivo Welch, 2000. "Views of Financial Economists on the Equity Premium and on Professional Controversies," Yale School of Management Working Papers, Yale School of Management ysm122, Yale School of Management.
  4. Ait-Sahalia, Y. & Brandt, M.W., 2001. "Variable Selection for Portfolio Choice," Papers, Manitoba - Department of Economics 34, Manitoba - Department of Economics.
  5. Jér�me B. Detemple & René Garcia & Marcel Rindisbacher, 2003. "A Monte Carlo Method for Optimal Portfolios," Journal of Finance, American Finance Association, American Finance Association, vol. 58(1), pages 401-446, 02.
  6. Roger G. Ibbotson & Peng Chen, 2003. "Long-Run Stock Returns: Participating in the Real Economy," Yale School of Management Working Papers, Yale School of Management ysm354, Yale School of Management.
  7. Joshua V. Rosenberg, 2003. "Nonparametric pricing of multivariate contingent claims," Staff Reports 162, Federal Reserve Bank of New York.
  8. Overdahl, James A., 1988. "The Early Exercise of Options on Treasury Bond Futures," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 23(04), pages 437-449, December.
  9. Yacine Aït-Sahalia & Andrew W. Lo, . "Nonparametric Estimation of State-Price Densities Implicit in Financial Asset Prices," CRSP working papers 332, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  10. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, vol. 20(3), pages 381-408, June.
  11. Wachter, Jessica A., 2002. "Portfolio and Consumption Decisions under Mean-Reverting Returns: An Exact Solution for Complete Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 37(01), pages 63-91, March.
  12. Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
  13. Ait-Sahalia, Yacine & Wang, Yubo & Yared, Francis, 2001. "Do option markets correctly price the probabilities of movement of the underlying asset?," Journal of Econometrics, Elsevier, Elsevier, vol. 102(1), pages 67-110, May.
  14. John R. Graham & Campbell R. Harvey, 2001. "Expectations of Equity Risk Premia, Volatility and Asymmetry from a Corporate Finance Perspective," NBER Working Papers 8678, National Bureau of Economic Research, Inc.
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Cited by:
  1. Vladimir Zdorovenin & Jacques Pézier, 2011. "Does Information Content of Option Prices Add Value for Asset Allocation?," ICMA Centre Discussion Papers in Finance, Henley Business School, Reading University icma-dp2011-03, Henley Business School, Reading University.
  2. Yoshihiko Sugihara & Nobuyuki Oda, 2010. "An Empirical Analysis of Equity Market Expectations in the Recent Financial Turmoil Using Implied Moments and Jump Diffusion Processes," IMES Discussion Paper Series 10-E-09, Institute for Monetary and Economic Studies, Bank of Japan.

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