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Option Valuation in the Presence of Market Imperfections

Series:

Andreas Bell

The Black/Scholes model and other option valuation concepts are enjoying widespread application by theoreticians and practitioners. However, one must not ignore that model values do not necessarily meet market prices. The reason is that the model rationales are based on a perfect, frictionless market environment that no options market in reality can ever provide. This book describes and discusses the numerous market imperfections found in reality and the effects they have on option prices. Many of these factors are not obvious at first glance (e.g. market impact costs, trading restrictions, non-lognormal stock price distributions, taxes, dividends, and others). It is shown how these factors can cause the significant, systematic deviations of market prices from model values that are found in a variety of empirical studies. Alternative models that have been devised in an attempt to alleviate these biases are shown to be unable to capture them in a consistent fashion. This work provides the theoretician with a comprehensive survey and discussion of the current academic knowledge on the subject and its implications for option market efficiency. For the practitioner, the book opens the black box of option valuation models and sharpens the eye for the difference between theoretical elegance and practical applicability.
Contents: Arbitrage bounds on option values - The Black/Scholes valuation rationale - The market environment in reality - Empirical evidence on Black/Scholes pricing biases - Alternative option valuation models - Incorporation of changing implied volatility - Embedded options.