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Rev Fin 1990; 3:493-521
© 1990 the Society for Financial Studies

Article

General equilibrium pricing of options on the market portfolio with discontinuous returns

V Naik1 and M Lee2
1 Faculty of Commerce and Business Administration, University of British Columbia, 2053 Main Mall, Vancouver, BC, Canada V6T 1Y8
2 University of Saskatchewan

Abstract

When the price process for a long-lived asset is of a mixed jump-diffusion type, pricing of options on that asset by arbitrage is not possible if trading is allowed only in the underlying asset and a risk-less bond. Using a general equilibrium framework, we derive and analyse option prices when the underlying asset is the market portfolio with discontinuous returns. The premium for the risk of jumps and the diffusions risk forms a significant part of the prices of the options. In this economy, an attempted replication of call and put options by the Black-Scholes type of trading strategies may require substantial infusion of funds when jumps occur. We study the cost and risk implications of such dynamic hedging plans.


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