Breaking Monte Carlo - Industry Standard Option Model Limits - Implications for Investors and Corporate Finance - Addendum - Equilibrium Option Pricing

Abstract

Implicit in industry standard option pricing models is the expectation that roughly 25% of stocks with 60% consistent volatility will septuple within 10 years, an extraordinary rate of appreciation.

The exceptionally high equilibrium anticipated returns for an improbably large percentage of high volatility stocks subsumed by industry standard option pricing models further reinforces the argument that standard option pricing models overvalue call options. Valuation anomalies become especially apparent when dealing with very long term options on high volatility issues. The bias to overprice call options stems from industry standard option pricing models’ basic premise of a lognormal, random stock price distribution.

If widely used option pricing models systematically overestimate the likelihood of upside stock price appreciation over long time periods, can investors with superior models find arbitrage opportunities? Are long term executive and employee option packages overvalued with, consequently, excessive expense recognized at grant? Might corporate finance managers find compelling capital strategies that existing option pricing models erroneously dismiss?

Keywords: Options, corporate finance, arbitrage, Black-Scholes, Cox-Rubenstein, Taleb and Haug, option expense, Cashless Buyback

JEL Classification: B23, C15, C21, C22, C24, G12, G13, 31, G32, M41