Option Pricing and Hedging on Correlated Stocks

40 Pages Posted: 19 Dec 2003

See all articles by Josep Perelló

Josep Perelló

University of Barcelona - Department of Physics

Jaume Masoliver

University of Barcelona - Department of Physics

Date Written: December 19, 2003

Abstract

We develop a theory for option pricing with perfect hedging in an inefficient market model where the underlying price variations are autocorrelated over a time. This is accomplished by assuming that the underlying noise in the system is derived by an Ornstein-Uhlenbeck, rather than from a Wiener process. After obtaining an effective one-dimensional market model, we achieve a closed expression for the European call price within the Black-Scholes framework and find that our price is always lower than the Black-Scholes price. We obtain the same price if we start from a modified portfolio although now we get a different hedging strategy than that of Black-Scholes. We compare these strategies and study the sensitivity of the call price to several parameters where the correlation effects are also observed.

Keywords: Option pricing, Ornstein-Uhlenbeck, Market model, inefficient market, Black-Scholes

JEL Classification: G12, C50, C41, G10, C6

Suggested Citation

Perello, Josep and Masoliver, Jaume, Option Pricing and Hedging on Correlated Stocks (December 19, 2003). Available at SSRN: https://ssrn.com/abstract=270268 or http://dx.doi.org/10.2139/ssrn.270268

Josep Perello (Contact Author)

University of Barcelona - Department of Physics ( email )

Diagonal, 647
Barcelona, E-08028
Spain
+34 9 34021150 (Phone)
+34 34021149 (Fax)

Jaume Masoliver

University of Barcelona - Department of Physics ( email )

Barcelona, E-08028
Spain
00 34 3 402 11 59 (Phone)
00 34 3 402 11 49 (Fax)

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