THE RISK AND PRICE VOLATILITY OF STOCK-OPTIONS IN GENERAL EQUILIBRIUM

The traditional valuation formulas for options were derived in a complete market setting and were based on the no-arbitrage principle. If the asset structure is incomplete, the presence of options affects the linear subspace spanned by the payoffs of the existing assets, and the pricing of options and underlying primary assets becomes a simultaneous valuation problem. We characterize the relationship between the prices of options and the prices of the stocks on which the options are written in a general equilibrium model where options are non-redundant assets. Contrary to the predictions of the Black-Scholes-Merton theory, in our model investor preferences have an impact on the relationship between the prices of primary and derivative assets.