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Option Pricing and Momentum

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  • Rodriguez, J.C.

    (Tilburg University, Center for Economic Research)

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    Abstract

    If managers are reluctant to fully adjust dividends to changes in earnings, stock returns and changes in the dividend yield will tend to be negatively correlated. When this is the case, stock returns will exhibit positive autocorrelation, or mo- mentum. This paper studies the pricing of options in such a situation, within a new model in which the dividend yield is an a¢ ne function of past stock returns. The model accommodates momentum in stock returns under complete markets, and, moreover, it renders preference-free formulas for European options. A momentum- inducing dividend yield implies that calls will be overpriced (underpriced) relative to puts after stock price increases (declines), a prediction in line with the findings of recent empirical research in finance, and that the Black-Scholes formula with constant dividend yield underprices out-of-the money options.

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    Bibliographic Info

    Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 2007-93.

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    Date of creation: 2007
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    Handle: RePEc:dgr:kubcen:200793

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    Web page: http://center.uvt.nl

    Related research

    Keywords: Options; Momentum; Stochastic convenience yield;

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    References

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    1. Mark Broadie & Jérôme B. Detemple & Eric Ghysels & Olivier Torrès, 1996. "American Options with Stochastic Dividends and Volatility: A Nonparametric Investigation," CIRANO Working Papers 96s-26, CIRANO.
    2. Andrew W. Lo & Jiang Wang, 1994. "Implementing Option Pricing Models When Asset Returns Are Predictable," NBER Working Papers 4720, National Bureau of Economic Research, Inc.
    3. Rodriguez, J.C., 2007. "A Preference-Free Formula to Value Commodity Derivatives," Discussion Paper 2007-92, Tilburg University, Center for Economic Research.
    4. 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.
    5. Kaushik Amin & Joshua D. Coval & H. Nejat Seyhun, 2004. "Index Option Prices and Stock Market Momentum," The Journal of Business, University of Chicago Press, vol. 77(4), pages 835-874, October.
    6. Harvey, Campbell R & Whaley, Robert E, 1991. " S&P 100 Index Option Volatility," Journal of Finance, American Finance Association, vol. 46(4), pages 1251-61, September.
    7. Geske, Robert, 1978. "The Pricing of Options with Stochastic Dividend Yield," Journal of Finance, American Finance Association, vol. 33(2), pages 617-25, May.
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    Cited by:
    1. Rodriguez, J.C., 2007. "A Preference-Free Formula to Value Commodity Derivatives," Discussion Paper 2007-92, Tilburg University, Center for Economic Research.

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