Description: This paper develops an option pricing model that takes cost of capital concepts as its foundation rather than dynamic replication. The resulting model, called the 'C' measure in this paper, is related to the family of Affine Jump Diffusion models that are well known in the finance literature, so it is fairly easy to understand and implement. We argue that this is a reasonable model to use for estimating equity implied volatilities that are beyond the five- to 10-year horizon that can typically be observed in today‘s capital markets. The paper concludes with a short discussion of how to grade from observable market data to the 'C' measure.

Description: Regularization, by means of trading restrictions, is an effective way to obtain sparse replicating portfolios. By including only the most relevant replicating instruments, the resulting portfolio is more efficient computationally, easier to interpret, and better able to approximate the liability on an out-of-sample basis. The instruments selected depend largely on their respective trading costs. This paper evaluates a number of alternative methods for specifying trading costs. We find that trading costs based on simple statistics of the instrument and liability cash flows are an effective choice in practice. Presented at 2010 Enterprise Risk Management Symposium, Society of Actuaries, April 12-15, 2010.