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Alan
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New paper -- Option-based Equity Risk Premiums

November 1st, 2019, 4:52 am

If you have an interest in the equity risk premium, this new paper may be of interest.

Equity risk premiums are like interest rates -- in the sense that they both are time-varying and have a term structure.

But, just exactly how do you find that term structure? That's the question that I answer.   
 
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DavidJN
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Re: New paper -- Option-based Equity Risk Premiums

November 1st, 2019, 1:23 pm

I've only just downloaded your paper, so these are only my first thoughts. In a similar vein to Ross Recovery, you are imposing structure on utility to frame the  model. Why no mention of Ross? Or Peter Carr? In the late 1980's I took a rather different and arguably more direct approach that imposed structure on the problem by jointly testing an asset pricing model (CAPM).

Any of your work I've read has been solid, so I look forward to digging into your paper. Congrats for tackling a core financial engineering problem, the business has become rather dull with charlatans going on about data.
 
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Alan
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Re: New paper -- Option-based Equity Risk Premiums

November 1st, 2019, 2:49 pm

Hi David, 
  Thanks for downloading and the suggestions. Now that I look at it again, Ross's Recovery Theorem paper should definitely be mentioned.  I will try to relate it to what I am doing. Re Peter Carr, do you have a specific article from him in mind -- he has done so much!   Also, can you post a link to your paper?
 
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bearish
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Re: New paper -- Option-based Equity Risk Premiums

November 1st, 2019, 8:29 pm

Looks like a major undertaking! The paper David referred to is probably Carr & Yu, Journal of Derivatives, Fall 2012. It’s freely avalailable, as is a couple of videos of Peter lecturing on the topic.
 
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Alan
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Re: New paper -- Option-based Equity Risk Premiums

November 2nd, 2019, 2:46 am

Thanks, bearish.
 
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DavidJN
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Re: New paper -- Option-based Equity Risk Premiums

November 5th, 2019, 11:47 pm

Alan, my work was a failed attempt at a PhD thesis at what I consider to be a then narrow minded and unprofessional department in one of Canada's universities. I had bought data from the CBOE and had positive empirical results. Anyway, rather than continue trying to reason with a brick wall, I just packed it in and went into the industry, so, alas I have nothing left of it but the basic idea in my head. 
 
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Alan
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Re: New paper -- Option-based Equity Risk Premiums

November 6th, 2019, 5:41 pm

David, sorry to hear of your bad university experience. I expect the industry was more appreciative.

I am trying to work my way more carefully through the Ross Recovery literature: Ross, Carr & Yu, etc. While Ross Recovery is a very novel insight, my read so far is that the method requires, among other things, for stock prices to either:

(i) form (or be a component of) an (irreducible) finite-state Markov chain, or 
(ii) (if lying in a continuous or unbounded discrete state space), to be  "recurrent" .  

(A sufficient, but not necessary, condition for recurrence is having a stationary distribution). 

In my mind, this key recurrence requirement seems to preclude any stock price dynamics with long-run (mean) exponential growth -- including of course, special cases like GBM (Black-Scholes), GARCH, etc.  Ross himself, in his J. Finance article, showed recovery didn't work under GBM, as the risk-aversion parameter (under that evolution) cannot be recovered from option prices alone.

For everybody: 

Q1. Do I have this right?

Q2. If so, is insisting on "recurrent" stock prices not a deal-breaker in financial modelling?  (i.e., any plausible dynamical model will have (trend) exponential growth of prices?)
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