Viewpoint: Option Prices, Preferences, and State Variables

27 Pages Posted: 25 Jan 2005

See all articles by René Garcia

René Garcia

Université de Montréal - CIREQ - Département de sciences économiques; University of Montreal

Richard Luger

Emory University - Department of Economics

Eric Renault

University of North Carolina (UNC) at Chapel Hill - Department of Economics

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

Garcia, René and Luger, Richard and Renault, Eric, Viewpoint: Option Prices, Preferences, and State Variables. Available at SSRN: https://ssrn.com/abstract=654065

René Garcia (Contact Author)

Université de Montréal - CIREQ - Département de sciences économiques ( email )

C.P. 6128, succursale Centre-Ville
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Montreal, Quebec H3C 3J7
Canada
514-985-4014 (Phone)

University of Montreal ( email )

United States

Richard Luger

Emory University - Department of Economics ( email )

1602 Fishburne Drive
Atlanta, GA 30322
United States
404-727-0328 (Phone)
404-727-4639 (Fax)

Eric Renault

University of North Carolina (UNC) at Chapel Hill - Department of Economics ( email )

Chapel Hill, NC 27599
United States

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