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This paper starts with a top-down decentralized framework that prices each option based on its own risk behaviors. It then proposes a linear option pricing model that unites the decentralized pricing of different option contracts, not by assuming common dynamics, but by imposing common pricing on each risk source in proportion to the different risk levels. The model uses historical moment estimators to capture the behavior differences of different contracts and to anchor the breakeven contribution of each risk source. A cross-sectional regression of the model identifies the common pricing of the decentralized risk at each point in time. Historical analysis on yen and pound options shows that the model performs extremely well in explaining the currency options variation. The pricing errors from the model represent highly reverting statistical arbitrage opportunities, whereas the common pricing estimates strongly predict the future excess returns of the corresponding risk-targeting portfolios.
Liuren Wu is the Wollman Distinguished Professor of Finance at Zicklin School of Business, Baruch College, City University of New York. Professor Wu's research interests include option pricing, credit risk and term structure modeling, market microstructure, and general asset pricing. Professor Wu has published over 50 articles, many of them in top finance journals such as the Journal of Finance, the Journal of Financial Economics, Review of Financial Studies, the Journal of Financial and Quantitative Analysis, Management Science, and Journal of Monetary Economics. Mr. Wu has worked extensively as consultants in the finance industry, including data vendors, investment banks, and several fixed income, equity, and equity options hedge funds and market making firms. He has developed statistical arbitrage strategies, risk management procedures, optimal trade execution and market making strategies, and quantitative models for pricing fixed income and equity derivative securities.