Option Pricing Bounds and the Elasticity of the Pricing Kernel

James Huang ()

Review of Derivatives Research, 2004, vol. 7, issue 1, 25-51

Abstract: In this paper we use power functions as pricing kernels to derive option-pricing bounds. We derive option pricing bounds given the bounds of the elasticity of the true pricing kernel. The bounds of the elasticity of the true pricing kernel are closely related to the bounds of the representative investor's coefficient of relative risk aversion. This methodology produces a tighter upper call option bound than traditional approaches. As a special case we show how to use the Black--Scholes formula to obtain option pricing bounds under the assumption of lognormality.

Date: 2004
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