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Abstract

Option pricing is complicated by the theoretical existence of risk premiums. This article utilizes a testable methodology to extract the pricing impact resulting from these risk premiums. First, option prices (based on the full dynamics of the underlying) are computed under the assumption that these risk premiums are not priced. The pricing methodology is independent of any particular option-pricing model or distributional assumptions on the return process for the underlying. The difference between the actual market prices and these “no-premium base case” prices reflects the effect of risk premiums. For at-the-money, 13-week S&P 500 options trading from 1989 until 1993, the effect of risk premiums is statistically significant and averages slightly over 20% (in units of Black–Scholes implied volatility). A simple delta-hedging strategy is used to demonstrate the economic significance of risk premiums, as the trading strategy provides enough profit to absorb a crash similar in magnitude to the 1987 crash once every 6.20 years. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:1147–1178, 2002