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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26836
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| Title: | When are Options Overpriced? The Black-Scholes Model and Alternative
Characterizations of the Pricing Kernel |
| Authors: | Franke, Guntar
Stapleton, Richard C.
Subrahmanyam, Marti G. |
| Issue Date: | Jan-1999 |
| Series/Report no.: | FIN-99-003 |
| Abstract: | 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 implicaitons
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 contast,
declining elasticiy 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. |
| URI: | http://hdl.handle.net/2451/26836 |
| Appears in Collections: | Finance Working Papers
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