Using Option Pricing Theory to Infer About Equity Premiums

Knut Aase

No 2005/11, Discussion Papers from Norwegian School of Economics, Department of Business and Management Science

Abstract: 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.

Keywords: Historical equity premiums; perpetual American put option; equity premium puzzle; risk free rate puzzle; geometric Brownian motion; geometric Poisson process; CCAPM (search for similar items in EconPapers)
JEL-codes: G00 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2005-11-30
New Economics Papers: this item is included in nep-cfn, nep-fmk, nep-rmg and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
http://hdl.handle.net/11250/163598 (application/pdf)
Our link check indicates that this URL is bad, the error code is: 404 Not Found (http://hdl.handle.net/11250/163598 [302 Found]--> https://www.unit.no/brage-denne-lenken-er-ikke-lenger-gyldig [301 Moved Permanently]--> https://sikt.no/brage-denne-lenken-er-ikke-lenger-gyldig)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:hhs:nhhfms:2005_011

Access Statistics for this paper

More papers in Discussion Papers from Norwegian School of Economics, Department of Business and Management Science NHH, Department of Business and Management Science, Helleveien 30, N-5045 Bergen, Norway. Contact information at EDIRC.
Bibliographic data for series maintained by Stein Fossen ().