Arbitrage-Based Pricing When Volatility is Stochastic
Caltech Social Science Working Paper 977
41 Pages Posted: 5 Sep 1996
Date Written: July 1996
In one of the early attempts to model stochastic volatility, Clark  conjectured that the size of asset price movements is tied to the rate at which transactions occur. To formally analyze the econometric implications, he distinguished between transaction time and calendar time. The present paper exploits Clark's strategy for a different purpose, namely, asset pricing. It studies arbitrage-based pricing in economies where: (i)trade takes place in transaction time, (ii) there is a single state variable whose transaction-time price path is binomial, (iii) there are riskfree bonds with calendar-time maturities, and (iv) the relation between transaction time and calendar time is stochastic. The state variable could be interpreted in various ways. E.g., it could be the price of a share of stock, as in Black and Scholes , or a factor that summarizes changes in the investment opportunity set, as in Cox, Ingersoll and Ross  or one that drives changes in the term structure of interest rates (Ho and Lee , Heath, Jarrow and Morton ). Property (iv) generally introduces stochastic volatility in the process of the state variable when recorded in calendar time.
The paper investigates the pricing of derivative securities with calendar-time maturities. The restrictions obtained in Merton  using simple buy-and-hold arbitrage portfolio arguments do not necessarily obtain. Conditions are derived for all derivatives to be priced by dynamic arbitrage, i.e., for market completeness in the sense of Harrison and Pliska . A particular class of stationary economies where markets are indeed complete is characterized.
JEL Classification: D52, G13
Suggested Citation: Suggested Citation