Common Pricing of Decentralized Risk: A New Linear Option Pricing Model
This paper builds a new linear option pricing model by imposing common market pricing on decentralized risk exposure estimates. A cross-sectional regression of the options time decay on the decentralized risk exposures generates the market pricing estimate on each of the risk sources on that date. Empirical analysis on long histories of yen and pound options shows that this new linear option pricing model performs extremely well in explaining the cross-sectional variation of the options time decay, with median R-squared estimates at 99.6-99.7%. The analysis also shows that the historical risk estimators act as accurate benchmarks on the breakeven contribution of each risk source. The common market pricing estimate on each risk source measures the market pricing deviation of that risk source from its break-even contribution. It can be profitably applied to the market timing investment of the corresponding risk-targeting portfolio.
Liuren Wu is the Wollman Distinguished Professor of Finance at Zicklin School of Business, Baruch College, City University of New York. Professor Wu's research interests include option pricing, credit risk, and term structure modeling, market microstructure, and general asset pricing. Professor Wu has published over 50 articles, many of them in top finance journals such as the Journal of Finance, the Journal of Financial Economics, Review of Financial Studies, the Journal of Financial and Quantitative Analysis, Management Science, and Journal of Monetary Economics. Mr. Wu has worked extensively as consultants in the finance industry, including data vendors, investment banks, and several fixed-income, equity, and equity options hedge funds and market-making firms. As a consultant, he has developed statistical arbitrage strategies, risk management procedures, optimal trade execution and market-making strategies, and quantitative models for pricing fixed-income and equity derivative securities.