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Estimation Risk and Adaptive Behavior in the Pricing of Options

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Listed:
  • Barry, Christopher B
  • French, Dan W
  • Rao, Ramesh K S

Abstract

We consider the effects of uncertainty in the statistical parameters of the Gaussian process in the context of the Black-Scholes option pricing model. With continuous time observation of returns, uncertainty about the variance disappears over any finite time interval, but uncertainty about the mean diminishes at the rate of 1/" tau", where "tau" is the length of the time interval of observation. In a market in which participants base their portfolio decisions on the predictive distribution of returns, option prices will be higher than in a market in which uncertainty in the mean is ignored. Even though the mean parameter, "mu," is itself irrelevant in the Black-Scholes model, uncertainty about "mu" affects option values under our behavioral assumptions. Copyright 1991 by MIT Press.

Suggested Citation

  • Barry, Christopher B & French, Dan W & Rao, Ramesh K S, 1991. "Estimation Risk and Adaptive Behavior in the Pricing of Options," The Financial Review, Eastern Finance Association, vol. 26(1), pages 15-30, February.
    • Handle: RePEc:bla:finrev:v:26:y:1991:i:1:p:15-30
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    Cited by:

    1. Lo, Andrew W & Wang, Jiang, 1995. "Implementing Option Pricing Models When Asset Returns Are Predictable," Journal of Finance, American Finance Association, vol. 50(1), pages 87-129, March.
    2. Radu Tunaru, 2015. "Model Risk in Financial Markets:From Financial Engineering to Risk Management," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 9524, August.

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