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Pricing Stock Options with Stochastic Interest Rate

46 Pages Posted: 3 Oct 2011  

Menachem (Meni) Abudy

Bar-Ilan University - Graduate School of Business Administration

Yehuda (Yud) Izhakian

City University of New York, CUNY Baruch College - Zicklin School of Business - Department of Economics and Finance

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Date Written: October 3, 2011

Abstract

This paper constructs a closed-form generalization of the Black-Scholes model for the case where the short-term interest rate follows a stochastic Gaussian process. Capturing this additional source of uncertainty appears to have a considerable effect on option prices. We show that the value of the stock option increases with the volatility of the interest rate and with time to maturity. Our empirical tests support the theoretical model and demonstrate a significant pricing improvement relative to the Black-Scholes model. The magnitude of the improvement is a positive function of the option's time to maturity, the largest improvement being obtained for around-the-money options.

Keywords: Option, call option, put option, put-call parity, stochastic interest rate

JEL Classification: G12, G13

Suggested Citation

Abudy, Menachem (Meni) and Izhakian, Yehuda (Yud), Pricing Stock Options with Stochastic Interest Rate (October 3, 2011). Available at SSRN: https://ssrn.com/abstract=1937633 or http://dx.doi.org/10.2139/ssrn.1937633

Menachem (Meni) Abudy (Contact Author)

Bar-Ilan University - Graduate School of Business Administration ( email )

Ramat Gan
Israel

Yehuda (Yud) Izhakian

City University of New York, CUNY Baruch College - Zicklin School of Business - Department of Economics and Finance ( email )

17 Lexington Avenue
New York, NY 10010
United States

HOME PAGE: http://people.stern.nyu.edu/yizhakia/

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