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Implementing Option Pricing Models When Asset Returns Are Predictable

Year: 1995

Type: article

Abstract: ABSTRACT The predictability of an asset's returns will affect the prices of options on that asset, even though predictability is typically induced by the drift, which does not enter the option pricing formula. For discretely‐sampled data, predictability is linked to the parameters that do enter the option pricing formula. We construct an adjustment for predictability to the Black‐Scholes formula and show that this adjustment can be important even for small levels of predictability, especially for longer maturity options. We propose several continuous‐time linear diffusion processes that can capture broader forms of predictability, and provide numerical examples that illustrate their importance for pricing options.

Source: The Journal of Finance

DOI: 10.1111/j.1540-6261.1995.tb05168.x

Authors: ANDREW W. LO, JIANG WANG

Institutions: Boston University, Northwestern University, University of California, Los Angeles, Yale University, University of Chicago, Massachusetts Institute of Technology, The University of Texas at Austin

Language: English

Topic: Stochastic processes and financial applications

Subfield: Finance

Field: Economics, Econometrics and Finance

Domain: Social Sciences

Open Access status: green

OpenAlex ID: W2053315017

FWCI: 14.95

Cites: 74

Cited by: 217

Related to: 10