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Option Valuation and the Price of Risk

Listed author(s):
  • John Chalupa
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    A valuation model is presented for options on stocks for which Black- Scholes arbitrage does not entirely eliminate risk. The price dynamics of a portfolio of options and the underlying security is quantified by requiring that the excess reward-to-risk ratio of the portfolio be identical to that of the stock. The nonlinear evolution equation for the portfolio value is homogeneous of degree one. A representative distribution is obtained from recent stock-history time series; numerical solutions for European calls are usually close to the Black- Scholes values, but naked and covered calls have different valuations. For infinitesimal time steps and a lognormal stock-price distribution, the evolution equation reduces to the Black-Scholes form. An analytically tractable non-lognormal distribution is analyzed near option expiration, and a formula expressing the deviation from the lognormal case is obtained for an out-of-the-money call. The present model is discussed in the context of previous work, and the effect of nonlinearity on the valuation of a portfolio of derivative securities is considered.

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    Paper provided by EconWPA in its series Finance with number 9607009.

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    Length: 21 pages
    Date of creation: 24 Jul 1996
    Handle: RePEc:wpa:wuwpfi:9607009
    Note: Type of Document - LaTeX; prepared on IBM PC - LaTeX 2.09; to print on PostScript; pages: 21 ; figures: Three tables; no figures. Gentle Reader, your comments would be welcome.
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