Constantinides, George M. and Jackwerth, Jens Carsten and Perrakis, Stylianos (2007): Option Pricing: Real and RiskNeutral Distributions. Published in: Handbooks in Operations Research and Management Science: Financial Engineering , Vol. 15, : pp. 565591.

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Abstract
The central premise of the Black and Scholes [Black, F., Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy 81, 637–659] and Merton [Merton, R. (1973). Theory of rational option pricing. Bell Journal of Economics and Management Science 4, 141–184] option pricing theory is that there exists a selffinancing dynamic trading policy of the stock and risk free accounts that renders the market dynamically complete. This requires that the market be complete and perfect. In this essay, we are concerned with cases in which dynamic trading breaks down either because the market is incomplete or because it is imperfect due to the presence of trading costs, or both. Market incompleteness renders the riskneutral probability measure non unique and allows us to determine the option price only within a range. Recognition of trading costs requires a refinement in the definition and usage of the concept of a riskneutral probability measure. Under these market conditions, a replicating dynamic trading policy does not exist. Nevertheless, we are able to impose restrictions on the pricing kernel and derive testable restrictions on the prices of options.We illustrate the theory in a series of market setups, beginning with the single period model, the twoperiod model and, finally, the general multiperiod model, with or without transaction costs.We also review related empirical results that document widespread violations of these restrictions.
Item Type:  MPRA Paper 

Original Title:  Option Pricing: Real and RiskNeutral Distributions 
English Title:  Option Pricing: Real and RiskNeutral Distributions 
Language:  English 
Keywords:  Option; Pricing 
Subjects:  D  Microeconomics > D8  Information, Knowledge, and Uncertainty > D81  Criteria for DecisionMaking under Risk and Uncertainty 
Item ID:  11637 
Depositing User:  Jens Jackwerth 
Date Deposited:  24. Nov 2008 22:07 
Last Modified:  12. Feb 2013 12:10 
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URI:  http://mpra.ub.unimuenchen.de/id/eprint/11637 