Pricing Earthquake Options Without Replicating Portfolios

Summary

The note asks whether sellers of options tied to California earthquakes should price them using real-world earthquake probabilities. Its central point is that standard derivative pricing is most tightly constrained when an option payoff can be replicated by trading other assets. Replication links the option price to the cost of that portfolio, rather than to investors’ personal views of value.

An earthquake-contingent payoff has no stated replicating portfolio, so the note argues that no unique risk-neutral probability measure follows from replication. Sellers may therefore need to use subjective assessments of real-world event probabilities when valuing the exposure. The explanation is conceptual and uses a simple analogy about constructing one good from others; it provides no pricing formula, probability estimates, or empirical evidence. It also leaves open how sellers should account for risk aversion, capital costs, or uncertainty in earthquake models, all of which could affect an actual quote.

Key ideas

• Replication can constrain an option’s market price by linking its payoff to the cost of traded assets.
• Earthquake-contingent payoffs are presented as unreplicable in the market described.
• Without replication, the note says a risk-neutral probability measure is not available from the usual pricing argument.
• Subjective real-world probability assessments may therefore influence prices, alongside other factors not discussed.

Tags

# Options On Earthquakes


# Options On Earthquakes












As a financial innovation, the options market is introducing Options contracts based on California Earthquakes. In your own words, discuss the following:

True or False? “The sellers of Options on California Earthquakes should perform option pricing based on the real world probabilities of Earthquakes.”

## Answer by Arshdeep (score 8)

https://quant.stackexchange.com/a/64032

The heart of option pricing is the ability to replicate. If you can make a mango from apple and orange, the price of the mango is determined by the cost of an apple and an orange. People may value the mango less or more than that, but the market price is already constrained and there is no scope for pricing in these (real world) preferences. No replication means people can opine on the value of a mango and that value has a way of sneaking into the mango price.

If one sells options on earthquake events, there is no way to replicate that payoff so there is scope for subjective assessment (real world probabilities) driving the price. There is no concept of risk neutral probability here because there is no replication of the option payoff.

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.