On the Economic Premium Principle

Abstract

In this study, we propose an equilibrium pricing rule to capture a characteristic observed in the practical option market. The market has observed that the implied volatility derived from the Black-Scholes formula is monotonically decreasing with the strike price for the option, that is, it exhibits volatility skewness. Here, we construct a pricing method for the so-called economic premium principle. That is, we identify a pricing kernel from which we can evaluate the derivative from the market equilibrium. Our model demonstrates how to obtain a pricing kernel that satisfies the market equilibrium, and describes our equilibrium formula depicting the volatility skewness.