TY - JOUR
AU - Lo, Andrew W
AU - Wang, Jiang
TI - Implementing Option Pricing Models When Asset Returns Are Predictable
JF - National Bureau of Economic Research Working Paper Series
VL - No. 4720
PY - 1994
Y2 - April 1994
DO - 10.3386/w4720
UR - http://www.nber.org/papers/w4720
L1 - http://www.nber.org/papers/w4720.pdf
N1 - Author contact info:
Andrew W. Lo
MIT Sloan School of Management
100 Main Street, E62-618
Cambridge, MA 02142
Tel: 617/253-0920
Fax: 781/891-9783
E-Mail: alo-admin@mit.edu
Jiang Wang
MIT Sloan School of Management
100 Main Street, E62-614
Cambridge, MA 02142
Tel: 617/253-2632
Fax: 617/258-6855
E-Mail: wangj@mit.edu
AB - 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.
ER -