Pricing Stock Options with Stochastic Interest Rate
Menachem (Meni) Abudy
Graduate School of Business Administration - Bar Ilan University
Yehuda (Yud) Izhakian
New York University (NYU) - Leonard N. Stern School of Business
NYU Working Paper No.
This paper constructs a closed-form generalization of the Black-Scholesmodel for the case where the short-term interest rate follows astochastic Gaussian process. Capturing this additional source ofuncertainty appears to have a considerable effect on option prices. Weshow that the value of the stock option increases with the volatility ofthe interest rate and with time to maturity. Our empirical tests supportthe theoretical model and demonstrate a significant pricing improvementrelative to the Black-Scholes model. The magnitude of the improvement isa positive function of the option's time to maturity, the largestimprovement being obtained for around-the-money options.
Number of Pages in PDF File: 46
Keywords: Option, call option, put option, stochastic interest rate, term structure of interest rates, Black and Scholes, put-call parityworking papers series
Date posted: October 15, 2011
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