NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Implementing Option Pricing Models When Asset Returns Are Predictable

Andrew W. Lo, Jiang Wang

NBER Working Paper No. 4720
Issued in April 1994
NBER Program(s):   AP

Option pricing formulas obtained from continuous-time no- arbitrage arguments such as the Black-Scholes formula generally do not depend on the drift term of the underlying asset's diffusion equation. However, the drift is essential for properly implementing such formulas empirically, since the numerical values of the parameters that do appear in the option pricing formula can depend intimately on the drift. In particular, if the underlying asset's returns are predictable, this will influence the theoretical value and the empirical estimate of the diffusion coefficient å. We develop an adjustment to the Black-Scholes formula that accounts for predictability and show that this adjustment can be important even for small levels of predictability, especially for longer-maturity options. We propose a class of continuous-time linear diffusion processes for asset prices that can capture a wider variety of predictability, and provide several numerical examples that illustrate their importance for pricing options and other derivative assets.

download in pdf format
   (593 K)

email paper

This paper is available as PDF (593 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Published: Journal of Finance, vol. 50, no. 1, March 1995.

Users who downloaded this paper also downloaded these:
Bates w5129 Testing Option Pricing Models
Lo and Wang w7625 Trading Volume: Definitions, Data Analysis, and Implications of Portfolio Theory
Lo, Mamaysky, and Wang w7613 Foundations of Technical Analysis: Computational Algorithms, Statistical Inference, and Empirical Implementation
 
Publications
Activities
Meetings
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us