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Modeling the non-linear behaviour of option price deviations from the Black Scholes model

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Author Info

  • Andros Gregoriou
  • Niloy Bose
  • M. Emranul Haque

Abstract

Purpose – The purpose of this paper is to test for and model non-linearities in option price deviations from the Black Scholes (BS) model in FTSE 100 index options over the time period 1997-2006. Design/methodology/approach – The economic specification and estimation methodology is outlined, the data are discussed, and the empirical results are analysed. Findings – The tests reject the linearity hypothesis and the paper shows that the exponential smooth transition autoregressive model is capable of capturing the non-linear behaviour of option price misalignments. The paper finds that even though FTSE 100 index options are heavily traded, transaction costs prevent rapid adjustments of option prices from their “optimal” value. Originality/value – The paper presents new empirical evidence, which explicitly allows for the possibility that option price misalignments from the BS price can be characterised by a non-linear mean reverting process.

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Bibliographic Info

Article provided by Emerald Group Publishing in its journal Journal of Economic Studies.

Volume (Year): 37 (2010)
Issue (Month): 1 (January)
Pages: 26-35

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Handle: RePEc:eme:jespps:v:37:y:2010:i:1:p:26-35

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Web page: http://www.emeraldinsight.com

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Related research

Keywords: Economic models; Options markets; Pricing; Transaction costs;

References

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  1. John Elder & Peter E. Kennedy, 2001. "Testing for Unit Roots: What Should Students Be Taught?," The Journal of Economic Education, Taylor & Francis Journals, vol. 32(2), pages 137-146, January.
  2. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  3. Kyriacos Kyriacou & Jakob B. Madsen & Bryan Mase, 2006. "Does inflation exaggerate the equity premium?," Journal of Economic Studies, Emerald Group Publishing, vol. 33(5), pages 344-356, November.
  4. Sarantis, Nicholas, 1999. "Modeling non-linearities in real effective exchange rates," Journal of International Money and Finance, Elsevier, vol. 18(1), pages 27-45, January.
  5. Andros Gregoriou, 2007. "The Asymmetry of the Price Impact of Block Trades and the Bid-Ask Spread. Evidence from the London Stock Exchange," Money Macro and Finance (MMF) Research Group Conference 2006 76, Money Macro and Finance Research Group.
  6. Lennard van Gelder & Ad Stokman, 2006. "Regime transplants in GDP growth forecasting: A recipe for better predictions?," DNB Working Papers 106, Netherlands Central Bank, Research Department.
  7. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  8. Yamei Liu & Walter Enders, 2003. "Out-of-Sample Forecasts and Nonlinear Model Selection with an Example of the Term Structure of Interest Rates," Southern Economic Journal, Southern Economic Association, vol. 69(3), pages 520-540, January.
  9. Bakshi, Gurdip & Cao, Charles & Chen, Zhiwu, 2000. "Pricing and hedging long-term options," Journal of Econometrics, Elsevier, vol. 94(1-2), pages 277-318.
  10. Granger, Clive W. J. & Terasvirta, Timo, 1993. "Modelling Non-Linear Economic Relationships," OUP Catalogue, Oxford University Press, number 9780198773207.
  11. Davidson, Russell & MacKinnon, James G., 1993. "Estimation and Inference in Econometrics," OUP Catalogue, Oxford University Press, number 9780195060119.
  12. Christos Ioannidis & David A. Peel & Michael J. Peel, 2003. "The Time Series Properties of Financial Ratios: Lev Revisited," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 30(5-6), pages 699-714.
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