Probing option prices for information (Q2642481)

The authors investigate the problem: how option prices may be employed to recover additional information, when the market is considered as possibly reflecting this additional information. The stock price is modeled in the first instance as a risk neutral martingale. Then the authors develop option pricing formulae by conditioning on specific information about future events that is the subject of the probe. Typically when one conditions the probability law for the underlying asset price or its volatility on future events, one obtains new probabilities that are generally referred to as bridge laws. The proposed methodology is based on identifying and applying such bridge laws and is focused on applications of bridge laws to equity markets as mechanisms for designing specific informational probes. The authors consider conditioning in the context of models that are employed in pricing equity options. The classical models of \textit{F. Black} and \textit{M. Scholes} [J. Polit. Econ. 81, 637--654 (1973; Zbl 1092.91524)] and \textit{R. C. Merton} [Econometrica 41, 867--887 (1973; Zbl 0283.90003)] are taken up first. This is followed by a variety of stochastic volatility models that permit conditioning on future volatility and include \textit{S. Heston} [``A closed-form solution for options with stochastic volatility with applications to bond and currency options'', Rev. Financ. Stud. 6, No. 2, 327--343 (1993; \url{doi:10.1093/rfs/6.2.327})], \textit{E. Nicolato} and \textit{E. Venardos} [Math. Finance 13, No. 4, 445--466 (2003; Zbl 1105.91020)] and \textit{P. Carr} et al. [Math. Finance 13, No. 3, 345--382 (2003; Zbl 1092.91022)]. There are also considered conditioning on an asymptotic dividend stream, under two assumed asymptotic dividend policies, but only within the classical context of the geometric Brownian motion model. In all cases the authors develop either in explicit form the density for the underlying asset price under a specific bridge assumption, or when this is not tractable, an explicit form for the characteristic function of the logarithm of the stock price. Finally it is mentioned that some of the bridge laws developed here are also useful in simulating stochastic volatility model using stratified sampling methods that condition on the level of the final stock price.