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A Test Of A General Equilibrium Stock Option Pricing Model

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  • Peter Bossaerts
  • Pierre Hillion

Abstract

An empirical version of the Cox, Ingersoll, and Ross (1985a) call option pricing model is derived, assuming execution price uncertainty in the options market. the pricing restrictions come in the form of moment conditions in the option pricing error. These can be estimated and tested using a version of the method of simulated moments (MSM). Simulation estimates, obtained by discretely approximating the risk‐neutral processes of the underlying stock price and the interest rate, are substituted for analytically unknown call prices. the asymptotics and other aspects of the MSM estimator are discussed. the model is tested on transaction prices at 15‐minute intervals. It substantially outperforms the Black‐Scholes model. the empirical success of the Cox‐Ingersoll‐Ross model implies that the continuous‐time interest rate implicit in synchronous transaction quotes of 90‐day Treasury‐bill futures contracts is an‐albeit noisy‐proxy for the instantaneous volatility on common stock. the process of the instantaneous volatility is found to be close to nonstationary. It is well approximated by a heteroskedastic unit‐root process. With this approximation, the Cox‐Ingersoll‐Ross model only slightly overprices long‐maturity options.

Suggested Citation

  • Peter Bossaerts & Pierre Hillion, 1993. "A Test Of A General Equilibrium Stock Option Pricing Model," Mathematical Finance, Wiley Blackwell, vol. 3(4), pages 311-347, October.
    • Handle: RePEc:bla:mathfi:v:3:y:1993:i:4:p:311-347
    DOI: 10.1111/j.1467-9965.1993.tb00091.x
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    Cited by:

    1. David S. Bates, 1993. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in thePHLX Deutschemark Options," NBER Working Papers 4596, National Bureau of Economic Research, Inc.
    2. Eric Ghysels & Valentin Patilea & Eric Renault & Olivier Torrès, 1997. "Nonparametric Methods and Option Pricing," CIRANO Working Papers 97s-19, CIRANO.
    3. Christian M. Hafner & Wolfgang HÄrdle, 2000. "Discrete time option pricing with flexible volatility estimation," Finance and Stochastics, Springer, vol. 4(2), pages 189-207.
    4. Bossaerts, Peter & Hillion, Pierre, 1997. "Local parametric analysis of hedging in discrete time," Journal of Econometrics, Elsevier, vol. 81(1), pages 243-272, November.

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