This file is part of IDEAS, which uses RePEc data


[ Papers | Articles | Software | Books | Chapters | Authors | Institutions | JEL Classification | NEP reports | Search | New papers by email | Author registration | Rankings | Volunteers | FAQ | Blog | Help! ]

Implementing Option Pricing Models When Asset Returns Are Predictable

Author info | Abstract | Publisher info | Download info | Related research | Statistics
Author Info
 Lo, Andrew W
Wang, Jiang

Additional information is available for the following registered author(s):

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. The authors 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. They 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. Copyright 1995 by American Finance Association.

Download Info
To download:

If you experience problems downloading a file, check if you have the proper application to view it first. Information about this may be contained in the File-Format links below. In case of further problems read the IDEAS help file. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://links.jstor.org/sici?sici=0022-1082%28199503%2950%3A1%3C87%3AIOPMWA%3E2.0.CO%3B2-8&origin=repec
File Format: application/pdf
File Function: full text
Download Restriction: Access to full text is restricted to JSTOR subscribers. See http://www.jstor.org for details.

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Publisher Info
Article provided by American Finance Association in its journal Journal of Finance.

Volume (Year): 50 (1995)
Issue (Month): 1 (March)
Pages: 87-129
Download reference. The following formats are available: HTML, plain text, BibTeX, RIS (EndNote), ReDIF
Handle: RePEc:bla:jfinan:v:50:y:1995:i:1:p:87-129

Contact details of provider:
Web page: http://www.afajof.org/
More information through EDIRC

Order Information:
Web: http://www.afajof.org/membership/join.asp

For technical questions regarding this item, or to correct its listing, contact: (Christopher F. Baum).

Related research
Keywords:

Other versions of this item:

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Chen, Nai-Fu, 1991. " Financial Investment Opportunities and the Macroeconomy," Journal of Finance, American Finance Association, vol. 46(2), pages 529-54, June. [Downloadable!] (restricted)
  2. Christopher A. Sims, 1980. "Martingale-Like Behavior of Prices," NBER Working Papers 0489, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Bekaert, Geert & Hodrick, Robert J, 1992. " Characterizing Predictable Components in Excess Returns on Equity and Foreign Exchange Markets," Journal of Finance, American Finance Association, vol. 47(2), pages 467-509, June. [Downloadable!] (restricted)
    Other versions:
  4. Harrison, J Michael & Pitbladdo, Richard & Schaefer, Stephen M, 1984. "Continuous Price Processes in Frictionless Markets Have Infinite Variation," Journal of Business, University of Chicago Press, vol. 57(3), pages 353-65, July. [Downloadable!] (restricted)
  5. Bruce D. Grundy, . "Option Prices and the Underlying Asset's Return Distribution (Reprint 012)," Rodney L. White Center for Financial Research Working Papers 11-91, Wharton School Rodney L. White Center for Financial Research.
  6. Chen, Nai-Fu & Roll, Richard & Ross, Stephen A, 1986. "Economic Forces and the Stock Market," Journal of Business, University of Chicago Press, vol. 59(3), pages 383-403, July. [Downloadable!] (restricted)
  7. Barry, Christopher B & French, Dan W & Rao, Ramesh K S, 1991. "Estimation Risk and Adaptive Behavior in the Pricing of Options," The Financial Review, Eastern Finance Association, vol. 26(1), pages 15-30, February.
  8. John Y. Campbell & Pierre Perron, 1991. "Pitfalls and Opportunities: What Macroeconomists Should Know About Unit Roots," NBER Technical Working Papers 0100, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  9. Heaton, John & Lucas, Deborah, 1992. "The effects of incomplete insurance markets and trading costs in a consumption-based asset pricing model," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 601-620. [Downloadable!] (restricted)
  10. Jegadeesh, Narasimhan, 1990. " Evidence of Predictable Behavior of Security Returns," Journal of Finance, American Finance Association, vol. 45(3), pages 881-98, July. [Downloadable!] (restricted)
  11. Campbell, John Y & Hamao, Yasushi, 1992. " Predictable Stock Returns in the United States and Japan: A Study of Long-Term Capital Market Integration," Journal of Finance, American Finance Association, vol. 47(1), pages 43-69, March. [Downloadable!] (restricted)
    Other versions:
  12. Grundy, Bruce D, 1991. " Option Prices and the Underlying Asset's Return Distribution," Journal of Finance, American Finance Association, vol. 46(3), pages 1045-69, July. [Downloadable!] (restricted)
  13. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March. [Downloadable!] (restricted)
  14. Harvey, Campbell R., 1989. "Time-varying conditional covariances in tests of asset pricing models," Journal of Financial Economics, Elsevier, vol. 24(2), pages 289-317. [Downloadable!] (restricted)
  15. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April. [Downloadable!] (restricted)
  16. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October. [Downloadable!] (restricted)
  17. Poterba, James M. & Summers, Lawrence H., 1988. "Mean reversion in stock prices : Evidence and Implications," Journal of Financial Economics, Elsevier, vol. 22(1), pages 27-59, October. [Downloadable!] (restricted)
    Other versions:
  18. Campbell, John Y & Ammer, John, 1993. " What Moves the Stock and Bond Markets? A Variance Decomposition for Long-Term Asset Returns," Journal of Finance, American Finance Association, vol. 48(1), pages 3-37, March. [Downloadable!] (restricted)
    Other versions:
  19. Bessembinder, Hendrik & Chan, Kalok, 1992. "Time-varying risk premia and forecastable returns in futures markets," Journal of Financial Economics, Elsevier, vol. 32(2), pages 169-193, October. [Downloadable!] (restricted)
  20. Ferson, Wayne E & Kandel, Shmuel & Stambaugh, Robert F, 1987. " Tests of Asset Pricing with Time-Varying Expected Risk Premiums and Market Betas," Journal of Finance, American Finance Association, vol. 42(2), pages 201-20, June. [Downloadable!] (restricted)
  21. Cecchetti, Stephen G. & Lam, Pok-sang & Mark, Nelson C., 1993. "The equity premium and the risk-free rate : Matching the moments," Journal of Monetary Economics, Elsevier, vol. 31(1), pages 21-45, February. [Downloadable!] (restricted)
    Other versions:
  22. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 145-166. [Downloadable!] (restricted)
  23. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144. [Downloadable!] (restricted)
    Other versions:
  24. Andrew B. Abel, . "Exact Solutions for Expected Rates of Return Under Markov Regime Switching: Implications for the Equity Premium Puzzle," Rodney L. White Center for Financial Research Working Papers 9-92, Wharton School Rodney L. White Center for Financial Research.
    Other versions:
  25. Keim, Donald B. & Stambaugh, Robert F., 1986. "Predicting returns in the stock and bond markets," Journal of Financial Economics, Elsevier, vol. 17(2), pages 357-390, December. [Downloadable!] (restricted)
    Other versions:
  26. Black, Fischer & Scholes, Myron S, 1972. "The Valuation of Option Contracts and a Test of Market Efficiency," Journal of Finance, American Finance Association, vol. 27(2), pages 399-417, May. [Downloadable!] (restricted)
  27. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March. [Downloadable!] (restricted)
  28. Ferson, Wayne E, 1990. " Are the Latent Variables in Time-Varying Expected Returns Compensation for Consumption Risk?," Journal of Finance, American Finance Association, vol. 45(2), pages 397-429, June. [Downloadable!] (restricted)
  29. Andrew W. Lo, A. Craig MacKinlay, 1988. "Stock Market Prices do not Follow Random Walks: Evidence from a Simple Specification Test," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 1(1), pages 41-66. [Downloadable!] (restricted)
    Other versions:
  30. Kandel, Shmuel & Stambaugh, Robert F, 1990. "Expectations and Volatility of Consumption and Asset Returns," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 3(2), pages 207-32. [Downloadable!] (restricted)
  31. Ferson, Wayne E & Harvey, Campbell R, 1991. "The Variation of Economic Risk Premiums," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 385-415, April. [Downloadable!] (restricted)
  32. Leland, Hayne E, 1985. " Option Pricing and Replication with Transactions Costs," Journal of Finance, American Finance Association, vol. 40(5), pages 1283-1301, December. [Downloadable!] (restricted)
    Other versions:
  33. John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  34. Lehmann, Bruce N, 1990. "Fads, Martingales, and Market Efficiency," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 1-28, February. [Downloadable!] (restricted)
  35. Grundy, R.D., 1991. "Option Prices and the Underlying Asset's Return Distribution," Weiss Center Working Papers 11-91, Wharton School - Weiss Center for International Financial Research.
  36. De Bondt, Werner F M & Thaler, Richard, 1985. " Does the Stock Market Overreact?," Journal of Finance, American Finance Association, vol. 40(3), pages 793-805, July. [Downloadable!] (restricted)
  37. Chopra, Navin & Lakonishok, Josef & Ritter, Jay R., 1992. "Measuring abnormal performance : Do stocks overreact?," Journal of Financial Economics, Elsevier, vol. 31(2), pages 235-268, April. [Downloadable!] (restricted)
  38. Gibbons, Michael R. & Ferson, Wayne, 1985. "Testing asset pricing models with changing expectations and an unobservable market portfolio," Journal of Financial Economics, Elsevier, vol. 14(2), pages 217-236, June. [Downloadable!] (restricted)
  39. Bruce N. Lehmann, 1990. "Fads, Martingales, and Market Efficiency," NBER Working Papers 2533, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  40. Shmuel Kandel & Robert F. Stambaugh, . "Modeling Expected Stock Returns for Long and Short Horizons," Rodney L. White Center for Financial Research Working Papers 42-88, Wharton School Rodney L. White Center for Financial Research.
  41. Dybvig, Philip H & Ingersoll, Jonathan E, Jr, 1982. "Mean-Variance Theory in Complete Markets," Journal of Business, University of Chicago Press, vol. 55(2), pages 233-51, April. [Downloadable!] (restricted)
  42. Lo, Andrew W., 1986. "Statistical tests of contingent-claims asset-pricing models : A new methodology," Journal of Financial Economics, Elsevier, vol. 17(1), pages 143-173, September. [Downloadable!] (restricted)
  43. Jagannathan, Ravi, 1984. "Call options and the risk of underlying securities," Journal of Financial Economics, Elsevier, vol. 13(3), pages 425-434, September. [Downloadable!] (restricted)
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Laarni Bulan & Christopher J. Mayer & C. Tsuriel Somerville, 2006. "Irreversible Investment, Real Options, and Competition: Evidence from Real Estate Development," NBER Working Papers 12486, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  2. Raphael Markellos & Terence Mills, 2003. "Asset pricing dynamics," European Journal of Finance, Taylor and Francis Journals, vol. 9(6), pages 533-556, December. [Downloadable!] (restricted)
  3. Orazio Di Miscia, 2005. "Nonparametric estimation of diffusion process: a closer look," Finance 0504016, EconWPA. [Downloadable!]
  4. Christian Pierdzioch, 2000. "The Effectiveness of the FX Market Interventions of the Bundesbank During the Louvre Period: An Options-Based Analysis," Kiel Working Papers 971, Kiel Institute for the World Economy. [Downloadable!]
  5. Dirk Broeders, 2006. "Valuation of Conditional Pension Liabilities and Guarantees under Sponsor Vulnerabilities," DNB Working Papers 082, Netherlands Central Bank, Research Department. [Downloadable!]
  6. Andrew W. Lo & A. Craig MacKinlay & June Zhang, 1997. "Econometric Models of Limit-Order Executions," NBER Working Papers 6257, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  7. C. Hafner & H. Herwartz, . "Option Pricing under Linear Autoregressive Dynamics, Heteroskedasticity, and Conditional Leptokurtosis," Sonderforschungsbereich 373 1999-58, Humboldt Universitaet Berlin.
    Other versions:
  8. Han, Bin, 2004. "Limits of Arbitrage, Sentiment and Pricing Kernal: Evidences from Index Options," Working Paper Series 2004-2, Ohio State University, Charles A. Dice Center for Research in Financial Economics. [Downloadable!]
  9. Clapham, Eric & Gunnelin, Åke, 2003. "Rental Expectations and the Term Structure of Lease Rates," SIFR Research Report Series 16, Swedish Institute for Financial Research. [Downloadable!]
  10. Pindyck, Robert S., 1998. "The long-run evolution of energy prices," Working papers WP 4044-98., Massachusetts Institute of Technology (MIT), Sloan School of Management. [Downloadable!]
  11. David Bakstein, 2001. "The Pricing of Derivatives in Illiquid Markets," OFRC Working Papers Series 2001mf05, Oxford Financial Research Centre. [Downloadable!]
  12. Mikhail Chernov & A. Ronald Gallant & Eric Ghysels & George Tauchen, 1999. "A New Class of Stochastic Volatility Models with Jumps: Theory and Estimation," CIRANO Working Papers 99s-48, CIRANO. [Downloadable!]
  13. David Bakstein & Sam Howison, 2002. "A Risk-Neutral Parametric Liquidity Model for Derivatives," OFRC Working Papers Series 2002mf02, Oxford Financial Research Centre. [Downloadable!]
  14. John Hatgioannides & Spiros Mesomeris, 2005. "Mean Reversion in Equity Prices: the G-7 Evidence," Money Macro and Finance (MMF) Research Group Conference 2005 64, Money Macro and Finance Research Group. [Downloadable!]
  15. John S. Ying & Joel S. Sternberg, 2005. "The Impact of Serial Correlation on Option Prices in a Non- Frictionless Environment: An Alternative Explanation for Volatility Skew," Working Papers 05-12, University of Delaware, Department of Economics. [Downloadable!]
  16. P. Bossaerts & C. Hafner & W. H"Ardle, . "Foreign Exchange Rates Have Surprising Volatility," Sonderforschungsbereich 373 1996-68, Humboldt Universitaet Berlin.
  17. Rodriguez, J.C., 2007. "Option Pricing and Momentum," Discussion Paper 2007-93, Tilburg University, Center for Economic Research. [Downloadable!]
  18. Julio Lucia & Eduardo Schwartz, 2000. "Electricity prices and power derivatives: Evidence from the Nordic Power Exchange," University of California at Los Angeles, Anderson Graduate School of Management 1061, Anderson Graduate School of Management, UCLA. [Downloadable!]
Statistics
Access and download statistics

Did you know? Over five million full texts a year are downloaded through IDEAS.

This page was last updated on 2008-9-29.

This information is provided to you by IDEAS at the Department of Economics, College of Liberal Arts and Sciences, University of Connecticut using RePEc data on a server sponsored by the Society for Economic Dynamics.