The Stop-Loss Start-Gain Paradox and Option Valuation: A New Decomposition into Intrinsic and Time Value
The downside risk in a leveraged stock position can be eliminated by using stop-loss orders. The upside potential of such a position can be captured using contingent buy orders. The terminal payoff to this stop-loss start-gain strategy is identical to that of a call option, but the strategy costs less initially. This article resolves this paradox by showing that the strategy is not self-financing for continuous stock- price processes of unbounded variation. The resolution of the paradox leads to a new decomposition of an option's price into its intrinsic and time value. When stock price follows geometric Brownian motion, this decomposition is proven to be mathematically equivalent to the Black-Scholes (1973) formula. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.
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Volume (Year): 3 (1990)
Issue (Month): 3 ()
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