6. Stochastic Dominance and Further Theoretical and Empirical Option Research

This chapter starts by examining the ability of stochastic dominance (SD) theory to price options in the presence of randomly changing volatility of index returns in the frictionless economy or, failing that, the robustness of the SD empirical results to such dynamics. It then applies the SD approach to several alleged empirical anomalies such as the overpriced puts and straddles derived in no arbitrage-equilibrium models of the option markets. Last, it presents several topics of suggested empirical option research that rely on or can be explored by the SD principles introduced in this book. These topics include a suggested model of the intermediation market for index options that can derive the bid-ask spread under certain assumptions, and the pricing of options when there are behavioral elements in an investor’s utility function in making choices under risk.