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Estimation Risk and Adaptive Behavior in the Pricing of Options

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  • Barry, Christopher B
  • French, Dan W
  • Rao, Ramesh K S
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    Abstract

    We consider the effects of uncertainty in the statistical parameters of the Gaussian process in the context of the Black-Scholes option pricing model. With continuous time observation of returns, uncertainty about the variance disappears over any finite time interval, but uncertainty about the mean diminishes at the rate of 1/" tau", where "tau" is the length of the time interval of observation. In a market in which participants base their portfolio decisions on the predictive distribution of returns, option prices will be higher than in a market in which uncertainty in the mean is ignored. Even though the mean parameter, "mu," is itself irrelevant in the Black-Scholes model, uncertainty about "mu" affects option values under our behavioral assumptions. Copyright 1991 by MIT Press.

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    Bibliographic Info

    Article provided by Eastern Finance Association in its journal The Financial Review.

    Volume (Year): 26 (1991)
    Issue (Month): 1 (February)
    Pages: 15-30

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    Handle: RePEc:bla:finrev:v:26:y:1991:i:1:p:15-30

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    Web page: http://www.easternfinance.org/
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    Cited by:
    1. Lo, Andrew W & Wang, Jiang, 1995. " Implementing Option Pricing Models When Asset Returns Are Predictable," Journal of Finance, American Finance Association, vol. 50(1), pages 87-129, March.

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