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Option Pricing when the Variance Changes Randomly: Theory, Estimation, and an Application

Published online by Cambridge University Press:  06 April 2009

Louis O. Scott
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Abstract

In this paper, we examine the pricing of European call options on stocks that have variance rates that change randomly. We study continuous time diffusion processes for the stock return and the standard deviation parameter, and we find that one must use the stock and two options to form a riskless hedge. The riskless hedge does not lead to a unique option pricing function because the random standard deviation is not a traded security. One must appeal to an equilibrium asset pricing model to derive a unique option pricing function. In general, the option price depends on the risk premium associated with the random standard deviation. We find that the problem can be simplified by assuming that volatility risk can be diversified away and that changes in volatility are uncorrelated with the stock return. The resulting solution is an integral of the Black-Scholes formula and the distribution function for the variance of the stock price. We show that accurate option prices can be computed via Monte Carlo simulations and we apply the model to a set of actual prices.

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Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 22 , Issue 4 , December 1987, pp. 419 - 438
Copyright
Copyright © School of Business Administration, University of Washington 1987

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