Faculty Digital Archive

Archive@NYU >
Stern School of Business >
Finance Working Papers >

Please use this identifier to cite or link to this item: http://hdl.handle.net/2451/26836

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

Files in This Item:

File Description SizeFormat
wpa99003.pdf647.36 kBAdobe PDFView/Open

Items in Faculty Digital Archive are protected by copyright, with all rights reserved, unless otherwise indicated.


The contents of the FDA may be subject to copyright, be offered under a Creative Commons license, or be in the public domain.
Please check items for rights statements. For information about NYU’s copyright policy, see http://www.nyu.edu/footer/copyright-and-fair-use.html 
Valid XHTML 1.0 | CSS