Knowledge that Transforms

Recovering an Asset's Implied PDF from Option Prices: An Application to Crude Oil During the Gulf Crisis William R. Melick and Charles P. Thomas Journal of Financial and Quantitative Analysis Vol. 32, 1997, pp. 91-115

The paper explores the economic value of being able to span market outcomes through the use of options. We model an economy with a single risky asset. Consumption takes place at one date, corresponding to the horizon of all investors. Options on the consumption good are not redundant securities in the economy because volatility is uncertain. The model enables us to examine the benefits to investors of using options to optimize their investments. Within this model, the gains from the use of options appear to be relatively minor.

The informational role of prices contributes positively to their variability. In a noisy rational expectations equilibrium, traders rationally respond to price changes by revising their estimates of other traders' private signals and hence their own expectations of future dividends. The resultant shifts in traders' demands amplify any supply shock-induced price changes. We develop an infinite horizon noisy rational expectations model and calibrate, simulate, and test it using U.S. stock market data. The price variability in a heterogeneous information economy is shown to be 20% to 46% higher than in an otherwise equivalent economy in which all signals are publicly announced.

Ronald W. Masulis, Lakshmanan Shivakumar, Does Market Structure Affect the Immediacy of Stock Price Responses to News?, The Journal of Financial and Quantitative Analysis, Vol. 37, No. 4 (Dec., 2002), pp. 617-648

We provide empirical evidence on order submission strategy of investors with similar com-mitments to trade by comparing the execution costs of market orders and marketable limit orders (i.e., limit orders with the same trading priority as market orders). The results in-dicate the unconditional trading costs of marketable limit orders are significantly greater than market orders. We attribute the difference in costs to a selection bias and provide evidence suggesting the order submission strategy decision is based on prevailing market conditions and stock characteristics. After correcting for the selection bias, the results show the average trader chooses the order type with lower conditional trading costs. I.

We identify and characterize a class of term structure models where bond yields are quadratic functions of the state vector.We label this class the quadratic class and aim to lay a solid theoretical foundation for its future empirical application.We consider asset pricing in general and derivative pricing in particular under the quadratic class.We provide two general transform methods in pricing a wide variety of fixed income derivatives in closed or semi-closed form.We further illustrate how the quadratic model and the transform methods can be applied to more general settings.

This article studies the valuation of options written on the average level of a Markov process. The general properties of such options are examined. We propose a closed-form characterization in which the option payoff is contingent on cumulative catastrophe losses. In our framework, the loss rate is a mean-reverting Markov process, with no continuous martingale component. The model supposes that high loss levels have lower arrival rates. We analytically derive the cumulative loss process and its characteristic function. The resulting option model is promising.