Options on leveraged equity: theory and empirical tests

Article Abstract:

We develop an option pricing model for calls and puts written on leveraged equity in an economy with corporate taxes and bankruptcy costs. The model explains implied Black-Scholes volatility biases by relating them to the firm's structural characteristics such as leverage and debt covenants. We test the model by comparing predicted pricing biases with biases observed in a large cross-section of firms with liquid exchange trade option contracts. Our empirical study detects leverage related pricing biases. The magnitudes of these biases correspond to those predicted by our model. We also find significant pricing biases for firms financed primarily by short-term debt. This supports our model because short-term debt introduces net-worth hurdles similar to net-worth covenants. (Reprinted by permission of the publisher.)

Research, Models, Pricing, Leverage (Finance), Leverage, Short-term financing, Short term financing

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General properties of option prices

Article Abstract:

When the underlying price process is a one-dimensional diffusion, as well as in certain restricted stochastic volatility settings, a contingent claim's delta is bounded by the infimum and supremum of its delta at maturity. Further, if the claim's payoff is convex (concave), the claim's price is a convex (concave) function of the underlying asset's value. However, when volatility is less specialized, or when the underlying process is discontinuous or non-Markovian, a call's price can be a decreasing, concave function of the underlying price over some range, increasing with the passage of time, and decreasing in the level of interest rates. (Reprinted by permission of the publisher.)

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A generalization of the Brennan-Rubenstein approach for the pricing of derivatives

Article Abstract:

New factors necessary for the validity of risk-neutral option pricing models are discussed.

Commodity & service prices, Derivatives (Financial instruments), Company pricing policy

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