When are Options Overpriced? The Black-Scholes Model and Alternative Characterizations of the Pricing Kernel
AbstractThis paper examines the convexity bias introduced by pricing interest rate swaps off the Eurocurrency futures curve and the market's adjustment of this bias in prices over time. The convexity bias arises because of the difference between a futures contract and a forward contract on interest rates, since the payoff to the latter is non-linear in interest rates. Using daily data from 1987-1996, the differences between market swap rates and the swap rates implied from Eurocurrency futures prices are studied for the four major interest rate swap markets - $, £, DM and ¥. The evidence suggests that swaps were being priced off the futures curve (i.e. by ignoring the convexity adjustment) during the earlier years of the study, after which the market swap rates drifted below the rates implied by futures prices. The empirical analysis shows that this spread between the market and futures-implied swap rates cannot be explained by default risk differences, liquidity differences or information asymmetries between the swap and the futures markets. Using alternative term structure models (one-factor Vasicek, Cox-Ingersoll and Ross, Hull and White, Black and Karasinski, and the two-factor Heath, Jarrow and Morton), the theoretical value of the convexity bias is found to be related to the empirically observed swap-futures differential. We interpret these results as evidence of mispricing of swap contracts during the earlier years of the study, with a gradual elimination of that mispricing by incorporation of a convexity adjustment in swap pricing over time.
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Bibliographic InfoPaper provided by New York University, Leonard N. Stern School of Business- in its series New York University, Leonard N. Stern School Finance Department Working Paper Seires with number 99-003.
Date of creation: Dec 1999
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- Guenter Franke & Richard C. Stapleton & Marti G. Subrahmanyam, 1999. "When are Options Overpriced? The Black-Scholes Model and Alternative Characterisations of the Pricing Kernel," CoFE Discussion Paper 99-01, Center of Finance and Econometrics, University of Konstanz.
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- 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.
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- Canina, Linda & Figlewski, Stephen, 1993. "The Informational Content of Implied Volatility," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 659-81.
- Franke, Gunter & Stapleton, Richard C. & Subrahmanyam, Marti G., 1998. "Who Buys and Who Sells Options: The Role of Options in an Economy with Background Risk," Journal of Economic Theory, Elsevier, vol. 82(1), pages 89-109, September.
- Bick, Avi, 1987. "On the Consistency of the Black-Scholes Model with a General Equilibrium Framework," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(03), pages 259-275, September.
- Heston, Steven L, 1993. " Invisible Parameters in Option Prices," Journal of Finance, American Finance Association, vol. 48(3), pages 933-47, July.
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