02114cam a22002537 4500001000600000003000500006005001700011008004100028100001800069245012600087260006600213490004100279500001600320520105600336530006101392538007201453538003601525690009101561700001701652710004201669830007601711856003701787856003601824w4720NBER20140921025032.0140921s1994 mau||||fs|||| 000 0 eng d1 aLo, Andrew W.10aImplementing Option Pricing Models When Asset Returns Are Predictableh[electronic resource] /cAndrew W. Lo, Jiang Wang. aCambridge, Mass.bNational Bureau of Economic Researchc1994.1 aNBER working paper seriesvno. w4720 aApril 1994.3 aOption 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. aHardcopy version available to institutional subscribers. aSystem requirements: Adobe [Acrobat] Reader required for PDF files. aMode of access: World Wide Web. 7aG13 - Contingent Pricing • Futures Pricing2Journal of Economic Literature class.1 aWang, Jiang.2 aNational Bureau of Economic Research. 0aWorking Paper Series (National Bureau of Economic Research)vno. w4720.4 uhttp://www.nber.org/papers/w472041uhttp://dx.doi.org/10.3386/w4720