Implementing Option Pricing Models When Asset Returns are Predictable

JOURNAL OF FINANCE, Vol 50, No 1, March 1995

Posted: 20 Dec 1998

See all articles by Andrew W. Lo

Andrew W. Lo

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER); Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management; China Academy of Financial Research (CAFR); National Bureau of Economic Research (NBER)

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Abstract

The predictability of an asset's returns will affect option prices on that asset, even though predictability is typically induced by the drift which does not enter the option pricing formula. For discretely sampled data, predictability is linked to the parameters that do enter the option pricing formula. We construct an adjustment for predictability to the Black Scholes formula and show that this adjustment can be important even for small levels of predictability, especially for longer maturity options. We propose several continuous time linear diffusion processes that can capture broader forms of predictability, and provide numerical examples that illustrate their importance for pricing options.

JEL Classification: G12, G13

Suggested Citation

Lo, Andrew W. and Wang, Jiang, Implementing Option Pricing Models When Asset Returns are Predictable. JOURNAL OF FINANCE, Vol 50, No 1, March 1995. Available at SSRN: https://ssrn.com/abstract=5902

Andrew W. Lo (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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National Bureau of Economic Research (NBER) ( email )

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Massachusetts Institute of Technology (MIT) - Computer Science and Artificial Intelligence Laboratory (CSAIL)

Stata Center
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Jiang Wang

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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100 Main Street
Cambridge, MA 02142
United States
617-253-2632 (Phone)
617-258-6855 (Fax)

China Academy of Financial Research (CAFR)

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Shanghai P.R.China, 200030
China

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
United States

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