Strategies and Rational Decisions in the Securities Options Market
Summary
The reference has not verified this book in detail; the summary states only what the title, author and subject establish.
Burton Malkiel and Richard Quandt wrote this study of the options market in 1969, four years before the Black-Scholes paper and the opening of the Chicago Board Options Exchange. It describes options as they were then traded, over the counter through put and call dealers, and attempts to analyse the strategies available.
The method is expected utility analysis rather than arbitrage pricing. Malkiel and Quandt evaluate option strategies including buying calls, buying puts, writing covered calls, writing naked options, straddles and spreads, by computing expected returns and variances under assumed distributions of stock prices, and asking which strategies a rational investor with given preferences would choose. They also examine empirical data on option premiums to ask whether the market priced options in a manner consistent with rational valuation.
The book is a historical document. The approach it takes was superseded almost immediately by the no-arbitrage method, which prices options without reference to investor preferences or to expected stock returns, and which made the expected utility approach unnecessary. Its value now is as a record of how serious economists thought about options before the arbitrage insight, and as a description of a market structure that no longer exists. Readers wanting option analysis should go to any modern text.
Key takeaways 6
- Before the arbitrage pricing insight, options were analysed by computing expected returns and variances under assumed price distributions.
- Malkiel and Quandt found that over-the-counter option premiums in the 1960s were broadly consistent with rational valuation.
- Covered call writing was analysed as a preference-dependent strategy rather than as a short volatility position.
- The expected utility approach requires knowing the investor's preferences and the stock's expected return, both of which arbitrage pricing eliminates.
- The over-the-counter put and call dealer market provided limited liquidity and wide spreads compared with the exchange market that followed.
- The book documents that competent economists could not price options correctly before the replication argument was found.
Who should read it
Readers interested in the history of financial economics who want to see how options were analysed immediately before the arbitrage pricing breakthrough.
About Burton G. Malkiel
Chemical Bank Chairman's Professor of Economics Emeritus, Princeton University; Chief Investment Officer, Wealthfront; former Vanguard director
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