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Pricing Options on Assets with Predictable White Noise Returns

Listed author(s):
  • Angel León
  • Enrique Sentana

    ()

We study the effect of the predictability of an assets return on the prices of options on that asset, for models in which returns are serially uncorrelated, yet predictable on the basis of a larger information set. We show that return predictability may matter in a discrete time world, especially for longer maturity options. However, discrepancies between the frequency of trading and observation become relevant in estimating the model parameters. When trading is continuous, Black-Scholes is valid, and the sample variance of holding returns over finite periods is an appropriate estimator of the variance of instantaneous returns.

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File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmg_pdfs/dp267.pdf
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Paper provided by Financial Markets Group in its series FMG Discussion Papers with number dp267.

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Date of creation: Aug 1997
Handle: RePEc:fmg:fmgdps:dp267
Contact details of provider: Web page: http://www.lse.ac.uk/fmg/

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  1. Lo, Andrew W. (Andrew Wen-Chuan) & Wang, Jiang, 1959-, 1993. "Implementing option pricing models when asset returns are predictable," Working papers 3593-93., Massachusetts Institute of Technology (MIT), Sloan School of Management.
  2. Hua He., 1990. "Convergence from Discrete to Continuous Time Contingent Claims Prices," Research Program in Finance Working Papers RPF-199, University of California at Berkeley.
  3. John Y. Campbell, 1993. "Why Long Horizons: A Study of Power Against Persistent Alternatives," NBER Technical Working Papers 0142, National Bureau of Economic Research, Inc.
  4. Robert J. Shiller, 1984. "Stock Prices and Social Dynamics," Cowles Foundation Discussion Papers 719R, Cowles Foundation for Research in Economics, Yale University.
  5. Cox, John C. & Ross, Stephen A. & Rubinstein, Mark, 1979. "Option pricing: A simplified approach," Journal of Financial Economics, Elsevier, vol. 7(3), pages 229-263, September.
  6. John Y. Campbell, 1990. "A Variance Decomposition for Stock Returns," NBER Working Papers 3246, National Bureau of Economic Research, Inc.
  7. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-273, April.
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