Practical Applications of Option Pricing and Market Efficiency

Abstract

Traditionally, risk-neutral valuation and market efficiency have been used for different applications—the former for evaluating option and derivative pricing and the latter for evaluating equity portfolios.

This Practical Applications report is based on an interview with Robert Jarrow , Ronald E. and Susan P. Lynch Professor of Investment Management at the Samuel Curtis Johnson Graduate School of Management at Cornell University in Ithaca, NY. Jarrow wrote Option Pricing and Market Efficiency , the Fall 2013 issue of The Journal of Portfolio Management .

Jarrow’s article examines the relationship between option pricing and market efficiency. He introduces a theorem to examine market efficiency and test for asset price bubbles when pricing options.

“My research shows that the two concepts [option pricing and market efficiency] are linked, and that the standard derivative pricing methods have more restrictive assumptions than normally believed,” Jarrow tells us.