Inferring Risk-Averse Probability Distributions from Option Prices Using Implied Binomial Trees

Tom Arnold, Timothy Falcon Crack and Adam Schwartz

Chapter 2 in Financial Econometrics Modeling: Derivatives Pricing, Hedge Funds and Term Structure Models, 2011, pp 35-52 from Palgrave Macmillan

Abstract: Abstract We generalize the Rubinstein (1994) risk-neutral implied binomial tree (R-IBT) model to a physical-world risk-averse implied binomial tree (RA-IBT) model. The R-IBT and RA-IBT trees are bound together via a relationship requiring a risk premium (or a risk-adjusted discount rate) on the underlying asset at any node. The RA-IBT provides a powerful numerical platform for many empirical financial option and real option applications; these include probabilistic inference, pricing, and utility theory applications.

Keywords: Risk Aversion; Option Price; Risk Premium; Representative Agent; Relative Risk Aversion (search for similar items in EconPapers)
Date: 2011
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Persistent link: https://EconPapers.repec.org/RePEc:pal:palchp:978-0-230-29520-9_2

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DOI: 10.1057/9780230295209_2

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