Option Pricing and Market Efficiency

Abstract

This article dispels the common belief that option pricing and market efficiency are independent concepts, only weakly related at best. It shows that risk-neutral valuation, the standard approach for pricing derivatives, is true if (and only if) the market for the underlying asset is efficient with respect to the information set generating the price process’s evolution. The article explores implications of this insight for standard derivative-pricing models, including the need to test for asset price bubbles before using such models.