EXTREME RISK INITIATIVE NYU SCHOOL OF ENGINEERING WORKING PAPER SERIES

Unique Option Pricing Measure With Neither

Dynamic Hedging nor Complete Markets

arXiv:1405.2609v2 [q-fin.MF] 27 Oct 2014

Nassim Nicholas Taleb School of Engineering, NYU, & Former Option Trader

AbstractProof that under simple assumptions, such as constraints of Put-Call Parity, the probability measure for the
valuation of a European option has the mean derived from
the forward price which can, but does not have to be the
risk-neutral one, under any general probability distribution,
bypassing the Black-Scholes-Merton dynamic hedging argument,
and without the requirement of complete markets and other
strong assumptions. We confirm that the heuristics used by
traders for centuries are both more robust, more consistent, and
more rigorous than held in the economics literature. We also
show that options can be priced using infinite variance (finite
mean) distributions.

I. BACKGROUND

Option valuations methodologies have been used by traders

for centuries, in an effective way (Haug and Taleb, 2010). In
addition, valuations by expectation of terminal payoff forces
the mean of the probability distribution used for option prices
be be that of the forward, thanks to Put-Call Parity and,
should the forward be risk-neutrally priced, so will the option
be. The Black Scholes argument (Black and Scholes, 1973,
Merton, 1973) is held to allow risk-neutral option pricing
thanks to dynamic hedging, as the option becomes redundant
(since its payoff can be built as a linear combination of cash
and the underlying asset dynamically revised through time).
This is a puzzle, since: 1) Dynamic Hedging is not operationally feasible in financial markets owing to the dominance
of portfolio changes resulting from jumps, 2) The dynamic
hedging argument doesnt stand mathematically under fat
tails; it requires a very specific "Black Scholes world" with
many impossible assumptions, one of which requires finite
quadratic variations, 3) Traders use the same Black-Scholes
"risk neutral argument" for the valuation of options on assets
that do not allow dynamic replication, 4) Traders trade options
consistently in domain where the risk-neutral arguments do not
apply 5) There are fundamental informational limits preventing
the convergence of the stochastic integral.1
There have been a couple of predecessors to the present thesis that Put-Call parity is sufficient constraint to enforce some
structure at the level of the mean of the underlying distribution,
such as Derman and Taleb (2005), Haug and Taleb (2010).
These approaches were heuristic, robust though deemed handwaving (Ruffino and Treussard, 2006). In addition they showed
that operators need to use the risk-neutral mean. What this
paper does is

It goes beyond the "handwaving" with formal proofs.

It uses a completely distribution-free, expectation-based
approach and proves the risk-neutral argument without
dynamic hedging, and without any distributional assumption.
Beyond risk-neutrality, it establishes the case of a unique
pricing distribution for option prices in the absence of
such argument. The forward (or future) price can embed
expectations and deviate from the arbitrage price (owing
to, say, regulatory or other limitations) yet the options
can still be priced at a distibution corresponding to the
mean of such a forward.
It shows how one can practically have an option market
without "completeness" and without having the theorems
of financial economics hold.

These are done with solely two constraints: "horizontal",

i.e. put-call parity, and "vertical", i.e. the different valuations
across strike prices deliver a probability measure which is
shown to be unique. The only economic assumption made
here is that the forward exits, is tradable in the absence
of such unique forward price it is futile to discuss standard
option pricing. We also require the probability measures to
correspond to distributions with finite first moment.
Preceding works in that direction are as follows. Breeden
and Litzenberger (1978) and Dupire(1994), show how option
spreads deliver a unique probability measure; there are papers
establishing broader set of arbitrage relations between options
such as Carr and Madan (2001)2.
However 1) none of these papers made the bridge between
calls and puts via the forward, thus translating the relationships
from arbitrage relations between options delivering a probability distribution into the necessity of lining up to the mean
of the distribution of the forward, hence the risk-neutral one
(in case the forward is arbitraged.) 2) Nor did any paper show
that in the absence of second moment (say, infinite variance),
we can price options very easily. Our methodology and proofs
make no use of the variance. 3) Our method is vastly simpler,
more direct, and robust to changes in assumptions.
We make no assumption of general market completeness.
Options are not redundant securities and remain so. Table 1

2 See also Green and Jarrow (1987) and Nachman(1988). We have known
about the possibility of risk neutral pricing without dynamic hedging since
Harrison and Kreps (1979) but the theory necessitates extremely strong and
severely unrealistic assumptions, such as strictly complete markets and a
multiperiod pricing kernel

1 Further,

in a case of scientific puzzle, the exact formula called "BlackScholes-Merton" was written down (and used) by Edward Thorp in a
heuristic derivation by expectation that did not require dynamic hedging, see
Thorpe(1973).

EXTREME RISK INITIATIVE NYU SCHOOL OF ENGINEERING WORKING PAPER SERIES

summarizes the gist of the paper.3

II. P ROOF
Define C(St0 , K, t) and P (St0 , K, t) as European-style call
and put with strike price K, respectively, with expiration t, and
S0 as an underlying security at times t0 , t t0 , and St the
possible value of the underlying security at time t.
A. Case 1: Forward as risk-neutral measure
Rt
1
Define r = tt
t0 rs ds,Rthe return of a risk-free money
0
t
1
market fund and = tt
t0 s ds the payout of the asset
0
(continuous dividend for a stock, foreign interest for a currency).
We have the arbitrage forward price FtQ :
FtQ = S0

(1 + r)(tt0 )
S0 e(r)(tt0 )
(1 + )(tt0 )

TABLE I
M AIN PRACTICAL DIFFERENCES BETWEEN THE DYNAMIC HEDGING
ARGUMENT AND THE STATIC P UT-C ALL PARITY WITH SPEADING ACROSS
STRIKES .

Black-Scholes
Merton

Put-Call Parity
with Spreading

Type

Continuous rebalancing.

Interpolative
static hedge.

Market Assumptions

1)
Continuous
Markets, no gaps,
no jumps.

1)
Gaps
and
jumps acceptable.
Continuous
Strikes,
or
acceptable
number of strikes.

2) Ability to borrow and lend underlying asset for

all dates.

2) Ability to
borrow and lend
underlying asset
for single forward
date.

3) No transaction
costs in trading
asset.

3) Low transaction costs in trading options.

Probability
Distribution

Requires all moments to be finite.

Excludes the class
of slowly varying
distributions

Requires finite 1st

moment (infinite
variance is acceptable).

Market
Completeness

Achieved
through dynamic
completeness

Not required (in

the
traditional
sense)

Realism of
Assumptions

Low

High

Convergence

In probability (uncertain; one large

jump changes expectation)
Only used after
"fudging"
standard
deviations
per
strike.

Pointwise

(1)

by arbitrage, see Keynes 1924. We thus call FtQ the future (or
forward) price obtained by arbitrage, at the risk-neutral rate.
Let FtP be the future requiring a risk-associated "expected
return" m, with expected forward price:
FtP = S0 (1 + m)(tt0 ) S0 em (tt0 ) .

(2)

Remark: By arbitrage, all tradable values of the forward

price given St0 need to be equal to FtQ .
"Tradable" here does not mean "traded", only subject to
arbitrage replication by "cash and carry", that is, borrowing
cash and owning the secutity yielding d if the embedded
forward return diverges from r.
B. Derivations
In the following we take F as having dynamics on its own
irrelevant to whether we are in case 1 or 2 hence a unique
probability measure Q.
Define = [0, ) = AK AcK where AK = [0, K] and
c
AK = (K, ).
Consider a class of standard (simplified) probability spaces
(, i ) indexed
by i, where i is a probability measure, i.e.,
R
satisfying di = 1.

Theorem 1. For a given maturity T, there is a unique measure

Q that prices European puts and calls by expectation of
terminal payoff.

This measure can be risk-neutral in the sense that it prices

the forward FtQ , but does not have to be and imparts rate of
return to the stock embedded in the forward.
3 The

famed Hakkanson paradox is as follows: if markets are complete

and options are redudant, why would someone need them? If markets are
incomplete, we may need options but how can we price them? This discussion
may have provided a solution to the paradox: markets are incomplete and we
can price options.
4 Option prices are not unique in the absolute sense: the premium over
intrinsic can take an entire spectrum of values; it is just that the put-call
parity constraints forces the measures used for puts and the calls to be the
same and to have the same expectation as the forward. As far as securities
go, options are securities on their own; they just have a strong link to the
forward.

Fitness
Reality

to

Portmanteau, using specific distribution adapted to

reality

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Lemma 1. For a given maturity T, there exist two measures

1 and 2 for European calls and puts of the same maturity
and same underlying security associated with the valuation by
expectation of terminal payoff, which are unique such that, for
any call and put of strike K, we have:
Z
fC d1 ,
(3)
C=

and
P =

fP d2 ,

(4)

hence 1 (AK ) = 2 (AK ) for all K [0, ). This equality

being true for any semi-closed interval, it extends to any Borel
set.

Lemma 3. Puts and calls are required, by static arbitrage,

to be evaluated at same as risk-neutral measure Q as the
tradable forward.
Proof:

respectively, and where fC and fP are (St K)+ and (K

St )+ respectively.
Proof: For clarity, set r and to 0 without a loss of
generality. By Put-Call Parity Arbitrage, a positive holding of
a call ("long") and negative one of a put ("short") replicates
a tradable forward; because of P/L variations, using positive
sign for long and negative sign for short:
C(St0 , K, t) P (St0 , K, t) + K = FtP

(5)

FtP

(11)

from Equation 5
Z

fC (K) d1

fP (K) d1 =

Ft dQ K

(12)

Taking derivatives on both sides, and since fC fP = S0 +

K, we get the Radon-Nikodym derivative:
dQ
=1
d1

C(St0 , K+K, t)P (St0 , K+K, t)+K+K = FtP (6)

1
K ,

Ft dQ ;

necessarily since FtP is tradable.

Put-Call Parity holds for all strikes, so:

for all K
Now a Call spread in quantities

(13)

for all values of K.

expressed as

C(St0 , K, t) C(St0 , K + K, t),

delivers $1 if St > K + K (that is, corresponds to the
indicator function 1S>K+K ), 0 if St K (or 1S>K ),
and the quantity times St K if K < St K + K,
that is, between 0 and $1 (see Breeden and Litzenberger,
1978). Likewise, consider the converse argument for a put,
with K < St .
At the limit, for K 0
Z
C(St0 , K, t)
= P (St > K) =
d1 .
(7)
K
AcK
By the same argument:
P (St0 , K, t)
=
K

d2 = 1
AK

AcK

d2 .

C(St0 , K, t) P (St0 , K, t)
+
=1
K
K
for all values of K, so
Z
Z
d2 ,
d1 =
AcK

AcK

F ORWARD

IS NOT RISK NEUTRAL

Consider the case where Ft is observable, tradable, and use

it solely as an underlying security with dynamics on its own.
In such a case we can completely ignore the dynamics of the
nominal underlying S, or use a non-risk
 neutral "implied" rate

log

F
S

linking cash to forward, m = tt00 . the rate m can embed

risk premium, difficulties in financing, structural or regulatory
impediments to borrowing, with no effect on the final result.
In that situation, it can be shown that the exact same results
as before apply, by remplacing the measure Q by another
measure Q . Option prices remain unique 5 .
IV.

Lemma 2. The probability measures of puts and calls are the

same, namely for each Borel set A in , 1 (A) = 2 (A).

WHERE THE

(8)

As semi-closed intervals generate the whole Borel -algebra

on , this shows that 1 and 2 are unique.

Proof: Combining Equations 5 and 6, dividing by

and taking K 0:

III. C ASE

1
K

(9)

(10)

COMMENT

We have replaced the complexity and intractability of

dynamic hedging with a simple, more benign interpolation
problem, and explained the performance of pre-Black-Scholes
option operators using simple heuristics and rules, bypassing
the structure of the theorems of financial economics.
Options can remain non-redundant and markets incomplete:
we are just arguing here for a form of arbitrage pricing (which
includes risk-neutral pricing at the level of the expectation of
the probability measure), nothing more. But this is sufficient
for us to use any probability distribution with finite first
moment, which includes the Lognormal, which recovers Black
Scholes.
5 We assumed 0 discount rate for the proofs; in case of nonzero rate, premia
are discounted at the rate of the arbitrage operator

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A final comparison. In dynamic heding, missing a single

hedge, or encountering a single gap (a tail event) can be disastrous as we mentioned, it requires a series of assumptions
beyond the mathematical, in addition to severe and highly
unrealistic constraints on the mathematical. Under the class of
fat tailed distributions, increasing the frequency of the hedges
does not guarantee reduction of risk. Further, the standard
dynamic hedging argument requires the exact specification of
the risk-neutral stochastic process between t0 and t, something
econometrically unwieldy, and which is generally reverse
engineered from the price of options, as an arbitrage-oriented
interpolation tool rather than as a representation of the process.
Here, in our Put-Call Parity based methodology, our ability
to track the risk neutral distribution is guaranteed by adding
strike prices, and since probabilities add up to 1, the degrees
of freedom that the recovered measure Q has in the gap area
between a strike price K and the next strike up, K + K,
are severely reduced, since the
R c in the interval is
R c measure
constrained by the difference AK d AK+K d. In other
words, no single gap between strikes can significantly affect
the probability measure, even less the first moment, unlike
with dynamic hedging. In fact it is no different from standard
kernel smoothing methods for statistical samples, but applied
to the distribution across strikes.6
The assumption about the presence of strike prices constitutes a natural condition: conditional on having a practical
discussion about options, options strikes need to exist. Further,
as it is the experience of the author, market-makers can add
over-the-counter strikes at will, should they need to do so.
ACKNOWLEDGMENT
Peter Carr, Marco Avellaneda, Hlyette Geman, Raphael
Douady, Gur Huberman, Espen Haug, and Hossein Kazemi.
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