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When are Options Overpriced? The Black-Scholes Model and Alternative Characterisations of the Pricing Kernel

  • Guenter Franke

    ()

    (Center of Finance and Econometrics)

  • Richard C. Stapleton

    ()

    (University of Strathclyde)

  • Marti G. Subrahmanyam

    ()

    (Stern School of Business, New York University)

An important determinant of option prices is the elasticity of the pricing kernel used to price all claims in the economy. In this paper, we first show that for a given forward price of the underlying asset, option prices are higher when the elasticity of the pricing kernel is declining than when it is constant. We then investigate the implications of the elasticity of the pricing kernel for the stochastic process followed by the underlying asset. Given that the underlying information process follows a geometric Brownian motion, we demonstrate that constant elasticity of the pricing kernel is equivalent to a Brownian Motion for the forward price of the underlying asset, so that the Black-Scholes formula correctly prices options on the asset. In contrast, declining elasticity implies that the forward price process is no longer a Brownian motion: it has higher volatility and exhibits autocorrelation. In this case, the Black-Scholes formula underprices all options.

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Paper provided by Center of Finance and Econometrics, University of Konstanz in its series CoFE Discussion Paper with number 99-01.

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Length: 30 pages
Date of creation: Jan 1999
Date of revision:
Handle: RePEc:knz:cofedp:9901
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  1. Stapleton, R C & Subrahmanyam, M G, 1990. "Risk Aversion and the Intertemporal Behavior of Asset Prices," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 677-93.
  2. Heston, Steven L, 1993. " Invisible Parameters in Option Prices," Journal of Finance, American Finance Association, vol. 48(3), pages 933-47, July.
  3. 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.
  4. 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.
  5. 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.
  6. Franke, Gunter, 1984. " Conditions for Myopic Valuation and Serial Independence of the Market Excess Return in Discrete Time Models," Journal of Finance, American Finance Association, vol. 39(2), pages 425-42, June.
  7. Brennan, M J, 1979. "The Pricing of Contingent Claims in Discrete Time Models," Journal of Finance, American Finance Association, vol. 34(1), pages 53-68, March.
  8. 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.
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