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Heterogeneous Information Arrival and Option Pricing

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  • Patrick K. Asea
  • Mthuli Ncube

Abstract

We model the arrival of heterogeneous information in a financial market as a doubly-stochastic Poisson process (DSPP). A DSPP is a member of the family of Poisson processes in which the mean value of the process itself is governed by a stochastic mechanism. We explore the implications for pricing stock, index and foreign currency options of the assumption that the under- lying security evolves as a mixed diffusion DSPP. We derive an intertemporal CAPM and demonstrate that accounting for heterogeneous information arrival may minimize the ubiquitous pricing bias 'smile-effect' of standard option pricing models. We propose a conceptually simple but numerically intensive maximum likelihood estimator of the parameters of a DSPP. A simulation study verifies the adequacy of the asymptotic approximations in finite samples.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5950.

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Date of creation: Mar 1997
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Publication status: published as Asea, Patrick K. & Ncube, Mthuli, 1998. "Heterogeneous information arrival and option pricing," Journal of Econometrics, Elsevier, vol. 83(1-2), pages 291-323.
Handle: RePEc:nbr:nberwo:5950

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  1. Scott, Louis O., 1987. "Option Pricing when the Variance Changes Randomly: Theory, Estimation, and an Application," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 22(04), pages 419-438, December.
  2. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(1-2), pages 125-144.
  3. MacBeth, James D & Merville, Larry J, 1979. "An Empirical Examination of the Black-Scholes Call Option Pricing Model," Journal of Finance, American Finance Association, American Finance Association, vol. 34(5), pages 1173-86, December.
  4. Jarrow, Robert A & Rosenfeld, Eric R, 1984. "Jump Risks and the Intertemporal Capital Asset Pricing Model," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 57(3), pages 337-51, July.
  5. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, Econometric Society, vol. 53(2), pages 363-84, March.
  6. Berry, Thomas D & Howe, Keith M, 1994. " Public Information Arrival," Journal of Finance, American Finance Association, American Finance Association, vol. 49(4), pages 1331-46, September.
  7. Brown, Stephen J & Dybvig, Philip H, 1986. " The Empirical Implications of the Cox, Ingersoll, Ross Theory of the Term Structure of Interest Rates," Journal of Finance, American Finance Association, American Finance Association, vol. 41(3), pages 617-30, July.
  8. Cox, John C. & Ross, Stephen A., 1976. "The valuation of options for alternative stochastic processes," Journal of Financial Economics, Elsevier, Elsevier, vol. 3(1-2), pages 145-166.
  9. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, Econometric Society, vol. 41(5), pages 867-87, September.
  10. Huang, Chi-fu, 1987. "An Intertemporal General Equilibrium Asset Pricing Model: The Case of Diffusion Information," Econometrica, Econometric Society, Econometric Society, vol. 55(1), pages 117-42, January.
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  12. Torben G. Andersen & Luca Benzoni, 2010. "Stochastic Volatility," CREATES Research Papers 2010-10, School of Economics and Management, University of Aarhus.
  13. Tauchen, George E & Pitts, Mark, 1983. "The Price Variability-Volume Relationship on Speculative Markets," Econometrica, Econometric Society, Econometric Society, vol. 51(2), pages 485-505, March.
  14. Naik, Vasanttilak & Lee, Moon, 1990. "General Equilibrium Pricing of Options on the Market Portfolio with Discontinuous Returns," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 3(4), pages 493-521.
  15. Harrison, J. Michael & Kreps, David M., 1979. "Martingales and arbitrage in multiperiod securities markets," Journal of Economic Theory, Elsevier, Elsevier, vol. 20(3), pages 381-408, June.
  16. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 81(3), pages 637-54, May-June.
  17. Penman, Stephen H., 1987. "The distribution of earnings news over time and seasonalities in aggregate stock returns," Journal of Financial Economics, Elsevier, Elsevier, vol. 18(2), pages 199-228, June.
  18. Heston, Steven L, 1993. " Invisible Parameters in Option Prices," Journal of Finance, American Finance Association, American Finance Association, vol. 48(3), pages 933-47, July.
  19. Back, Kerry, 1991. "Asset pricing for general processes," Journal of Mathematical Economics, Elsevier, vol. 20(4), pages 371-395.
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