Inclusion of ESG Ratings in Option Pricing

Abstract

This chapter develops ESG-valued option pricing to reflect both the financial and ESG worth of the underlying asset. In contrast to Chap. 12, this chapter develops the theory of ESG-valued option pricing using binomial trees employing discrete (rather than continuous) ESG-valued returns. Call option prices are developed using different domestic REIT tangent portfolios as the underlying and their values compared under changes of the ESG affinity parameter. Standard implied volatility surfaces are also derived from the computed call option prices and examined under changing values of the affinity parameter. The discrete option pricing framework enables the incorporation of microeconomic features such as the presence of informed traders, and assessment of option trader views on spot market direction.