IDEAS home Printed from
MyIDEAS: Login to save this paper or follow this series

Using Option Pricing Theory to Infer About Equity Premiums

  • Aase, Knut K.


    (Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration)

In this paper we make use of option pricing theory to infer about historical equity premiums. This we do by comparing the prices of an American perpetual put option computed using two different models: The first is the standard one with continuous, zero expectation, Gaussian noise, the second is a strikingly similar model, except that the zero expectation noise is of Poissonian type. The interesting fact that makes this comparison worthwhile, is that the probability distribution under the risk adjusted measure turns out to depend on the equity premium in the Poisson model, while this is not so for the standard, Brownian motion version. This difference is utilized to find the intertemporal, equilibrium equity premium. We apply this technique to the US equity data of the last century and find that, if the risk free short rate was around one per cent, this corresponds to a risk premium on equity about two and a half per cent. On the other hand, if the risk free rate was about four per cent, we find that this corresponds to an equity premium of around four and a half per cent. The advantage with our approach is that we only need equity data and option pricing theory, no consumption data was necessary to arrive at these conclusions. We round off the paper by investigating if the procedure also works for incomplete models.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Our checks indicate that this address may not be valid because: 403 Forbidden ( [303 See Other]--> If this is indeed the case, please notify (Stein Fossen)

Download Restriction: no

Paper provided by Department of Business and Management Science, Norwegian School of Economics in its series Discussion Papers with number 2005/11.

in new window

Length: 32 pages
Date of creation: 30 Nov 2005
Date of revision:
Handle: RePEc:hhs:nhhfms:2005_011
Contact details of provider: Postal: NHH, Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway
Phone: +47 55 95 92 93
Fax: +47 55 95 96 50
Web page:

More information through EDIRC

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-87, September.
  2. Campbell, John, 1996. "Understanding Risk and Return," Scholarly Articles 3153293, Harvard University Department of Economics.
  3. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  4. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  5. Bick, Avi, 1987. "On the Consistency of the Black-Scholes Model with a General Equilibrium Framework," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(03), pages 259-275, September.
  6. Merton, Robert C., 1975. "Option pricing when underlying stock returns are discontinuous," Working papers 787-75., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  7. Campbell, John, 1993. "Intertemporal Asset Pricing Without Consumption Data," Scholarly Articles 3221491, Harvard University Department of Economics.
  8. Knut Aase, 1999. "An Equilibrium Model of Catastrophe Insurance Futures and Spreads," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 24(1), pages 69-96, June.
  9. Aase, Knut K, 2005. "The perpetual American put option for jump-diffusions with applications," University of California at Los Angeles, Anderson Graduate School of Management qt31g898nz, Anderson Graduate School of Management, UCLA.
  10. Knut K. Aase, 2002. "Equilibrium Pricing in the Presence of Cumulative Dividends Following a Diffusion," Mathematical Finance, Wiley Blackwell, vol. 12(3), pages 173-198.
  11. Jan Ubøe & Bernt Øksendal & Knut Aase & Nicolas Privault, 2000. "White noise generalizations of the Clark-Haussmann-Ocone theorem with application to mathematical finance," Finance and Stochastics, Springer, vol. 4(4), pages 465-496.
  12. Robert C. Merton, 1973. "Theory of Rational Option Pricing," Bell Journal of Economics, The RAND Corporation, vol. 4(1), pages 141-183, Spring.
  13. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  14. Ellen R. McGrattan & Edward C. Prescott, 2003. "Average debt and equity returns: puzzling?," Staff Report 313, Federal Reserve Bank of Minneapolis.
  15. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
  16. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-43, June.
  17. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:hhs:nhhfms:2005_011. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Stein Fossen)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.