measuring the pricing error of the arbitrage pricing theory this article provides an exact bayesian frame work for analyzing the arbitrage pricing the ory apt based on the gibbs sampler we show how to obtain the exact posterior distributions for functions of interest in the factor model in particular we propose a measure of the apt pricing deviations and obtain its exact posterior distribution using monthly portfolio returns grouped by industry and market capitalization we find that there is little improvement in reduc ing the pricing errors by including more factors beyond the first one as an important extension of the asset pricing model of sharpe 1964 and lintner 196 5 ross 1976 1977 derived the arbitrage pricing theory apt which addresses a fundamental problem in finance to char acterize the expected return on a security the apt implies that the expected return is approximately a

start up complexity and the thickness of regional input markets start ups in different industry groups are classified according to their average complexity we find that thick regional input markets are conducive to start up activity in general and complex start ups in particular but that some inputs are more important than others

the alliance formation puzzle and capacity constraints the formation of an alliance in conflict situations is known to suffer from a collective action problem and from the potential of internal conflict we show that budget constraints of an intermediate size can overcome this strong disadvantage and explain the formation of alliances

networks in conflict theory and evidence from the great war of africa we study from both a theoretical and an empirical perspective how a network of military alliances and enmities affects the intensity of a conflict the model combines elements from network theory and from the politico economic theory of conflict we obtain a closed form characterization of the nash equilibrium using the equilibrium conditions we perform an empirical analysis using data on the second congo war a conflict that involves many groups in a complex network of informal alliances and rivalries the estimates of the fighting externalities are then used to infer the extent to which the conflict intensity can be reduced through i dismantling specific fighting groups involved in the conflict ii weapon embargoes iii interventions aimed at pacifying animosity among groups finally with the aid of a random utility model we study how policy shocks can induce a reshaping of the network structure

do call prices and the underlying stock always move in the same direction this article empirically analyzes some properties shared by all one dimensional diffusion option models using sp options are not redundant securities nor ideal hedging instruments puts and the underlying asset prices may go down together much of the extant knowledge about option pricing is based on the assumption that the underlying asset price follows a one dimensional diffusion process examples of such option pricing models include the classic black scholes 1973 merton 1973 the cox ross 1976 constant elasticity of variance the ones studied in derman and kani 1994 rubinstein 1994 bergman grundy and wiener 1996 bakshi cao and chen 1997 2000 and dumas fleming and whaley 1998 all models in the one dimensional diffusion class share three basic properties first call prices are monotonically increasing and put prices are monotonically decreasing in the underlying asset price the monotonicity property second as the underlying asset price is the sole source of uncertainty for all of its options option prices must be perfectly correlated with each other and with the underlying asset the perfect

mean variance theory in complete markets two paradigms in the pricing of risky assets are the complete markets model of arrow and debreu and mean variance pricing as embodied in the capital asset pricing model capm the former is primarily of theoretical interest in fact prior to the recent work of banz and miller 1978 and breeden and litzenberger 1978 there was little thought or hope of practical applications on the other hand the hegemony of the capm is due mostly to its apparent ease of applicability and to a lesser extent its empirical justification in a competitive market with no taxes transactions costs or institutional constraints on portfolio holdings the allocation of the available assets will be pareto optimal the end of period distribution of wealth or the consumption goods however will typically be pareto optimal only when there is available an arrow debreu security for each contingency since by definition a pareto superior reallocation is weakly preferred by all investors a complete set of arrow debreu markets should naturally arise provided they are not too costly to establish the complete markets model of arrow and debreu and the meanvariance capital asset pricing model capm are two paradigms of risky asset markets this paper provides an integration of these two theories we prove that the standard meanvariance separation theorem obtains in a complete market only if all investors have quadratic utility in addition the familiar capm pricing relation can hold for all assets in a complete market only if arbitrage opportunities exist on the positive side we show that the validity of this relation for the primary assets in a complete market is unaffected by the distribution of returns on the created financial assets

team contests with multiple pairwise battles abstract we consider a multi battle team contest in which players from two rival teams form pairwise matches to fight in distinct component battles which are carried out sequentially or partially

the price of a smile hedging and spanning in option markets the volatility smile changed drastically around the crash of 1987 and new option pricing models have been proposed to accommodate that change deterministic volatility models allow for more flexible volatility surfaces but refrain from introducing additional risk factors thus options are still redundant securities alternatively stochastic models introduce additional risk factors and options are then needed for spanning of the pricing kernel we develop a statistical test based on this difference in spanning using daily s p 500 index options data from 1986 95 our tests suggest that both in and out of the money options are needed for spanning the findings are inconsistent with deterministic volatility models but are consistent with stochastic models that incorporate additional priced risk factors such as stochastic volatility interest rates or jumps article published by oxford university press on behalf of the society for financial studies in its journal the review of financial studies

a nonlinear factor analysis of s p 500 index option returns growing evidence suggests that extraordinary average returns may be obtained by trading equity index options and that at least part of this abnormal performance is attributable to volatility and jump risk premia this paper asks whether such priced risk factors are alone sufficient to explain these average returns to provide an answer in as general as possible a setting i estimate a flexible class of nonlinear models using all s p 500 index futures options traded between 1986 and 2000 the results show that priced factors contribute to these expected returns but are insufficient to explain their magnitudes particularly for short term out of the money puts in a recent paper c oval and shumway 2001 examine the returns on deltahedged option positions focusing on the at the money straddle and find average returns close to minus 3 per week since over short time horizons these positions are approximately invariant to movements in the underlying index coval and shumway argue that their capm betas should be near zero and their expected returns close to the risk free rate they conclude that large deviations from the capm are the norm which they suggest is evidence that some other systematic factor such as stochastic volatility might be priced by the market similar conclusions are made by jackwerth 2000 who finds risk adjusted profitability from selling puts and by bakshi and kapadia 2003 who find that the volatility risk premium contributes significantly to higher prices for calls and puts buraschi and jackwerth 2001 concur suggesting that more than one priced risk factor is necessary to explain option prices a less direct set of evidence is the now standard observation that the black scholes implied volatilities of equity index options are upward biased predictors of future realized volatility numerous studies such as fleming ostdiek and whaley 1995 and christensen and prabhala 1998 document that implied volatilities of short term at the money equity index options are on average several percentage points higher than the volatilities realized over the option s

the relation between implied and realized volatility abstract previous research finds the volatility implied by s p 100 index option prices to be a biased and inefficient forecast of future volatility and to contain little or no incremental information beyond that in past realized volatility in contrast we find that implied volatility outperforms past volatility in forecasting future volatility and even subsumes the information content of past volatility in some of our specifications our results differ from previous studies because we use longer time series and nonoverlapping data a regime shift around the october 1987 crash explains why implied volatility is more biased in previous work

cumulative prospect theory option returns and the variance premium the variance premium and the pricing of out of the money otm equity index options are major challenges to standard asset pricing models we develop a tractable equilibrium model with cumulative prospect theory cpt preferences that can overcome both challenges the key insight is that the variance premium can be written as the expected return on a portfolio of otm call and put options and the probability weighting feature of cpt can explain the puzzlingly low returns observed for these options using gmm on a sample of u s index option returns between 1996 and 2010 we show that the cpt model ts well observed option prices and therefore the variance premium in a dynamic setting probability weighting and time varying equity return volatility combine to match the observed time series pattern of the variance premium

information alliances in contests with budget limits we study the role of information exchange that may occur in alliances in a contest without noise contestants learn their own limits of what they can spend in a contest they may also form alliances and learn the limits of all players who are within the same alliance then they decide independently about their own contest efforts alliance formation for the purpose of information exchange is beneficial for members of the same alliance and neutral for all other players also a merger between alliances is beneficial for their members further we identify and discuss the set of stable alliance combinations

on equilibrium player ordering in dynamic team contests we study equilibrium player ordering in a dynamic all pay contest between two teams the contest lasts two periods and each team consists of two players who perform in different periods on behalf of their teams the team with the higher aggregate output wins the prize which is a public good to its players each team has one stronger player and one weaker player and the two teams can differ in their values of the prize the teams maximize their winning odds by strategically assigning their players to different periods we find that when the intrateam heterogeneity in player ability is not excessive the teams would allocate their stronger players to the late positions as the anchormen when both the intrateam ability gap and interteam heterogeneity in teams values become excessively large the team with high value always places its stronger player in the early position who will place a large bid to preempt late competition jel c7 d7 d8

endogenous group formation in experimental contests abstract we experimentally study endogenous alliance formation and contest effort choices in a generic three player contest differences in intrinsic or extrinsic incentives to expend effort cause self selection weakly motivated players have an incentive to enter into an alliance and to free ride on strongly motivated players hence strong players prefer to stand alone self selection has direct consequences for effort in endogenously formed alliances but we also find evidence of an effort stimulating effect if players endogenously form an alliance which is in line with theories of in group favoritism the experimental evidence on self selection is in conformity with a theory analysis of the game

a new approach to international arbitrage pricing this paper uses a nonlinear arbitrage pricing model a conditional linear model and an unconditional linear model to price international equities bonds and forward currency contracts unlike linear models the nonlinear arbitrage pricing model requires no restrictions on the payoff space allowing it to price payoffs of options forward contracts and other derivative securities only the nonlinear arbitragepricing model does an adequate job of explaining the time series behavior of a cross section of international returns the idea that a few relevant state variables explain expected returns is the main driving force of the seminal papers of merton 1973 and ross 1976 these seminal ideas have been extended to the pricing of international assets by ikeda 1991 ross and walsh 1983 solnik 1974 1983 and stulz 1981 among others the key implication of these arbitrage pricing models is that only risks related to these factors state variables are relevant in determining asset prices testable implications of these international asset pricing models have been derived either by placing restrictions on the payoff structure i e payoffs are linear in factors as in ikeda 1991 ross and walsh 1983 and solnik 1983 or on the joint distributions of the payoffs and state variables as in constantinides 1989 these restrictions lead to the testable implication that expected asset returns are linear in the conditional covariances with the factor payoffs in what follows we refer to these models as linear arbitrage models or linear models

understanding index option returns this paper studies the returns from investing in index options previous research documents significant average option returns large capm alphas and high sharpe ratios and concludes that put options are mispriced we propose an alternative approach to evaluate the significance of option returns and obtain different conclusions instead of using these statistical metrics we compare historical option returns to those generated by commonly used option pricing models we find that the most puzzling finding in the existing literature the large returns to writing out of themoney puts is not even inconsistent with the black scholes model moreover simple stochastic volatility models with no risk premia generate put returns across all strikes that are not inconsistent with the observed data at the money straddle returns are more challenging to understand and we find that these returns are not inconsistent with explanations such as jump risk premia peso problems and estimation risk

distributional conflict and jurisdictional organization abstract this paper explores the endogenous formation of jurisdictions assuming the political process is a costly fight to acquire shares of the gnp pie in such a setting the stability of a unified jurisdiction is not necessarily determined by the preferences of the richest member region we also show that a system of federalism is especially significant in ameliorating distributional competition and conflict less resources are spent in aggregate on appropriative activities under a hierarchical system of federalism than in a unified jurisdiction with a single central government

on the formation of alliances in conflict and contests this paper examines the problem of the formation of alliances in conflict and more generally in contests with three players each player possesses an exogenous strategic endowment e g arms efforts rent seeking activity the outcome of contests including those between any alliances of players is governed by a contest success function csf in the three person one cake problem an alliance between two players against the third one will form if and only if the csf has an increasing returns characteristic when an alliance forms there is a tendency to be formed by the weaker players against the strongest player similar tendencies exist in other three person problems that i examine

optimal option portfolio strategies deepening the puzzle of index option mispricing traditional methods of asset allocation such as mean variance optimization are not adequate for option portfolios because the distribution of returns is non normal and the short sample of option returns available makes it difficult to estimate their distribution we propose a method to optimize a portfolio of european options held to maturity with a myopic objective function that overcomes these limitations in an out of sample exercise incorporating realistic transaction costs the portfolio strategy delivers a sharpe ratio of 0 82 with positive skewness this performance is mostly obtained by exploiting mispricing between options and not by loading on jump or volatility risk premia

rent dissipation when rent seekers are budget constrained in the original tullock 1975 1980 game an individual bidder s probability of winning with a bid b is proportional to br where the exponent reflects economies of scale in rent seeking different interpretations can be given to these probabilities first one may view r as a reflection of the political culture alternatively one may view r as a choice variable for a politician intuition suggests that a society with a high tolerance for the selling of political favors and politicians who are receptive to rent seeking would both induce greater rent seeking expenditures than other societies all else equal this paper shows that a lower value of r can actually lead to more rent dissipation than a higher value this paper also reinforces two points concerning rent seeking first the analysis confirms the robustness of under dissipation of rents even in the face of entry second it points out the importance of distinguishing between rent seeking expenditures and rent dissipation when bidders must borrow for example total expenditure may understate rent dissipation

approximating the asset pricing kernel this article tests a simple consumption based asset pricing model by approximating the true asset pricing kernel using low order orthonormal polynomials based on the model s state variables approximated kernels based solely on next period s consumption growth are not rejected by overall measures of model fit but they produce statistically and economically large pricing errors approximated kernels based on two quarters of future consumption growth and technology shocks have substantially improved overall fit in particular the best of these kernels are capable of eliminating the small firm effect a conventional approach to examining the implications of dynamic asset pricing models is to assume that markets are complete the economy is in equilibrium and that the unique state price deflator can be interpreted as the intertemporal marginal rate of substitution of a representative consumer given assumptions about the form of this unobservable utility function and on the observability of aggregate consumption the model can be tested by examining the conditional or unconditional covariation of estimated intertemporal marginal rates of substitution with measured asset returns the fact that this method of testing dynamic models requires strong assumptions is in and of itself not particularly troubling however the fact that these attempts have been almost uniformly inconsistent with the data on asset returns and consumption is problematic for example when the utility function is assumed to be time and state separable the absolute and relative levels of the real returns on risk free and risky securities see for example mehra and prescott 1985 and weil 1989 are inconsistent with the model s predictions the primary finding from a large literature testing consumption based models is that measured consumption is too smooth to rationalize the observed level and variability of asset returns for reasonable parameterizations of time separable utility functions an alternate approach pursued in this paper is to approximate the stateprice deflator or asset pricing kernel using orthonormal polynomials in a

group contests with internal conflict and power asymmetry we investigate simultaneous inter and intra group conflict in the shadow of within group power asymmetry and complementarity in members group conflict efforts a more symmetric group faces a higher degree of internal conflict and might expend more effort in external conflict when the group conflict effort technology is highly complementary depending on the degree of complementarity the stronger player s relative contribution to external conflict might be higher in a more asymmetric group and as a result it is possible for the weaker player to earn a higher payoff in the absence of any complementarity the rent dissipation is non monotonic with the within group power asymmetry

smart cafe cities testing human capital externalities in the boston metropolitan area abstract existing studies have explored only one or in some cases two mechanisms by which human capital externalities percolate at the macrogeographic levels this study however uses the 1990 massachusetts census data to test four mechanisms at the microgeographic levels in the boston metropolitan area labor market we propose that individual workers can learn from their occupational and industrial peers in the same local labor market through four channels depth of human capital stock marshallian labor market externalities jacobs labor market externalities and thickness of the local labor market we find that all types of human capital externalities are significant across census blocks different types of externalities attenuate at different speeds over distances for example the effect of human capital depth decays rapidly beyond three miles away from block centroids we conclude that knowledge spillovers are very localized within a microgeographic scope in cities that we call smart cafe cities

option prices under bayesian learning implied volatility dynamics and predictive densities abstract this paper shows that many of the empirical biases of the black and scholes option pricing model can be explained by bayesian learning effects in the context of an equilibrium model where dividend news evolve on a binomial lattice with unknown but recursively updated probabilities we derive closed form pricing formulas for european options learning is found to generate asymmetric skews in the implied volatility surface and systematic patterns in the term structure of option prices data on s p 500 index option prices is used to back out the parameters of the underlying learning process and to predict the evolution in the cross section of option prices the proposed model leads to lower out of sample forecast errors and smaller hedging errors than a variety of alternative option pricing models including black scholes and a garch model

valuation of american futures options theory and empirical tests this paper reviews the theory of futures option pricing and tests the valuation principles on transaction prices from the s p 500 equity futures option market the american futures option valuation equations are shown to generate mispricing errors which are systematically related to the degree the option is in the money and to the option s time to expiration the models are also shown to generate abnormal risk adjusted rates of return after transaction costs the joint hypothesis that the american futures option pricing models are correctly specified and that the s p 500 futures option market is efficient is refuted at least for the sample period january 28 1983 through december 30 1983 futures option contracts now trade on every major futures exchange and on a wide variety of underlying futures contracts the chicago mercantile exchange the chicago board of trade the new york futures exchange and the commodity exchange now collectively have more than twenty options written on futures contracts where the underlying spot commodities are financial assets such as stock portfolios bonds notes and eurodollars foreign currencies such as west german marks swiss francs and british pounds precious metals such as gold and silver livestock commodities such as cattle and hogs and agricultural commodities such as corn and soybeans moreover new contract applications are before the commodity futures trading commission and should be actively trading in the near future with the markets for these new contingent claims becoming increasingly active it is appropriate that the fundamentals of futures option valuation be reviewed and tested black 5 provides a framework for the analysis of commodity futures options although his work is explicitly directed at pricing european options on forward contracts it applies to european futures contracts as well if the riskless rate of interest is constant during the futures option life 1 the options currently

a contest success function for networks abstract this paper models conflict as a contest within a network of friendships and enmities we assume that each player is either in a friendly or in an antagonistic relation with every other player and players compete for winning by exerting costly efforts we axiomatically characterize a success function which determines the win probability of each player given the efforts and the network of relations in an extension we allow for varying intensities of friendships and enmities this framework allows for the study of strategic incentives and friendship formation under conflict as well as the application of stability concepts of network theory to contests

to deter or to moderate alliance formation in contests with incomplete information we consider two players choice about the formation of an alliance ahead of conflict in a framework with incomplete information about the strength of the potential ally when deciding on alliance formation players anticipate the self selection of other players and the informational value of own and other players choices in the absence of these signaling effects strong players have an incentive to stand alone which leads to a separating equilibrium this separating equilibrium can be destabilized by deception incentives if beliefs are updated on the basis of endogenous alliance formation choices weak players may find it attractive to appear strong in order to deter competitors from positive effort choices strong players may find it attractive to appear weak in order to give their competitors a false sense of security and then beat them with little effort moreover appearing weak allows players to free ride when alliances are formed jel d72 d74

systematic risk and the price structure of individual equity options this study demonstrates the impact of systematic risk on the prices of individual equity options the option prices are characterized by the level and slope of implied volatility curves and the systematic risk is measured as the proportion of systematic variance in the total variance using daily option quotes on the s and p 100 index and its 30 largest component stocks we show that after controlling for the underlying asset s total risk a higher amount of systematic risk leads to a higher level of implied volatility and a steeper slope of the implied volatility curve thus systematic risk proportion can help differentiate the price structure across individual equity options the author 2008 published by oxford university press on behalf of the society for financial studies all rights reserved for permissions please email journals permissions oxfordjournals org oxford university press

underreaction overreaction and increasing misreaction to information in the options market this paper investigates options market reaction to changes in the instantaneous variance of the underlying asset there are three main findings first options market investors underreact to individual daily changes in instantaneous variance second these same investors overreact to periods of mostly increasing or mostly decreasing daily changes in instantaneous variance third they tend to underreact overreact to current daily changes in instantaneous variance that are preceded mostly by daily changes of the opposite same sign the third finding can reconcile the first two and is also consistent with well established cognitive biases