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An Actuarial Theory of Option Pricing

Published online by Cambridge University Press:  10 June 2011

R.S. Clarkson
R.S. Clarkson
Affiliation:
Cherrybank, Manse Brae, Dalserf, Larkhall, Lanarkshire, ML9 3BN, U.K. Tel: +44 (0)1698 882451
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Abstract

Using an empirical approach to capital market returns analogous to that used for mortality rates by Halley more than three centuries ago to establish life assurance on a sound and scientific footing, a theory of option pricing is built up in terms of the same three key components as for life assurance premiums, namely the expected cost of claims, an allowance for expenses, and a contingency margin as a reserve against the risk of insolvency. The dimensionality of the process describing security returns to any future point in time is increased from two to three by the addition of systematic variability around ‘central values’ to the standard descriptors of expected return and variance of return. It is shown that this approach, which involves only common sense principles and elementary mathematics, has important theoretical, practical and regulatory advantages over the Black-Scholes and related methodologies of modern finance theory.

Keywords

Option PricingBlack-Scholes FormulaCox, RossRubinsteinDiffusion ProcessesDynamic Equilibrium ModelStochastic CalculusEquilibriumEfficient Market HypothesisRiskUncertaintyCentral Values
Type
Sessional meetings: papers and abstracts of discussions
Information
British Actuarial Journal , Volume 3 , Issue 2 , 01 June 1997 , pp. 321 - 409
Copyright
Copyright © Institute and Faculty of Actuaries 1997

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