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On the Relation Between Option and Stock Prices: A Convex Optimization Approach

Sloan School of Management, Massachusetts Institute of Technology, Cambridge, Massachusetts 02139
INSEAD, Fontainebleau 77300, France
dbertsim{at}mit.edu
ioana.popescu{at}insead.edu

The idea of investigating the relation of option and stock prices based just on the no-arbitrage assumption, but without assuming any model for the underlying price dynamics, has a long history in the financial economics literature. We introduce convex and, in particular semidefinite optimization methods, duality, and complexity theory to shed new light on this relation. For the single stock problem, given moments of the prices of the underlying assets, we show that we can find best-possible bounds on option prices with general payoff functions efficiently, either algorithmically (solving a semidefinite optimization problem) or in closed form. Conversely, given observable option prices, we provide best-possible bounds on moments of the prices of the underlying assets, as well as on the prices of other options on the same asset by solving linear optimization problems. For options that are affected by multiple stocks either directly (the payoff of the option depends on multiple stocks) or indirectly (we have information on correlations between stock prices), we find nonoptimal bounds using convex optimization methods. However, we show that it is NP-hard to find best possible bounds in multiple dimensions. We extend our results to incorporate transactions costs.

Subject classifications: Finance: asset pricing, options; Optimization: semidefinite, convex optimization.
History: Received July 1999; revision received July 2000; accepted September 2000.