American Economic Review Vol. 98 No. 2 2008
Contingent Claims Analysis and Life-Cycle Finance
Abstract
This paper explores the application of contingent claims analysis (CCA) to two important issues in life-cycle finance: investing for retirement, and deciding when, if ever, to switch careers. Contingent claims analysis is a methodology that grew out of the option pricing theory of Fischer Black, Robert C. Merton, and Myron Scholes. They derived the option pricing model by showing that there is a self-financing dynamic trading strategy that replicates the payoffs from a call option. In the absence of transaction costs, the law of one price and the force of arbitrage imply that the cost of the initial replicating portfolio is the price of the option. That same approach applies to any derivative security or contingent contract based on traded assets. For every dynamic trading strategy, there exists an equivalent contingent contract. In reality, most investors face substantial transactions costs and cannot trade even approximately continuously, as is done in the theoretical models. But in a modern, well-developed financial system, the lowest-cost transactors may have marginal trading costs close to zero, and can trade almost continuously. Thus, the lowest-cost producers of contingent contracts can approximate reasonably well the dynamic trading strategy, and in a competitive environment
- DOI
- 10.1257/aer.98.2.291
- Volume
- 98
- Issue
- 2
- Pages
- 291-296
- Language
- en
- Sources
- bibtex:phds-export.bib crossref openalex