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Viewpoint: Option prices, preferences, and state variables

Author

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  • René Garcia
  • Richard Luger
  • Éric Renault

Abstract

This paper surveys recent developments in the theory of option pricing. The emphasis is on the interplay between option prices and investors' impatience and their aversion to risk. The traditional view, steeped in the risk-neutral approach to derivative pricing, has been that these preferences play no role in the determination of option prices. However, the usual lognormality assumption required to obtain preference-free option pricing formulas is at odds with the empirical properties of financial assets. The lognormality assumption is easily reconcilable with those properties by the introduction of a latent state variable whose values can be interpreted as the states of the economy. The presence of a covariance risk with the state variable makes option prices depend explicitly on preferences. Generalized option pricing formulas, in which preferences matter, can explain several well-known empirical biases associated with preference-free models such as that of Black and Scholes (1973) and the stochastic volatility extensions of Hull and White (1987) and Heston (1993).

Suggested Citation

  • René Garcia & Richard Luger & Éric Renault, 2005. "Viewpoint: Option prices, preferences, and state variables," Canadian Journal of Economics, Canadian Economics Association, vol. 38(1), pages 1-27, February.
    • Handle: RePEc:cje:issued:v:38:y:2005:i:1:p:1-27
    DOI: 10.1111/j.0008-4085.2005.00266.x
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    Cited by:

    1. Wang, Xiao-Tian & Li, Zhe & Zhuang, Le, 2017. "Risk preference, option pricing and portfolio hedging with proportional transaction costs," Chaos, Solitons & Fractals, Elsevier, vol. 95(C), pages 111-130.
    2. Beare, Brendan K., 2011. "Measure preserving derivatives and the pricing kernel puzzle," Journal of Mathematical Economics, Elsevier, vol. 47(6), pages 689-697.
    3. Han, Hyojin & Khrapov, Stanislav & Renault, Eric, 2020. "The leverage effect puzzle revisited: Identification in discrete time," Journal of Econometrics, Elsevier, vol. 217(2), pages 230-258.

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