Hostname: page-component-78c5997874-8bhkd Total loading time: 0 Render date: 2024-11-02T23:39:39.875Z Has data issue: false hasContentIssue false

The Systematic Risk of Discretely Rebalanced Option Hedges

Published online by Cambridge University Press:  06 April 2009

Abstract

This paper demonstrates that Black-Scholes option pricing model hedge positions that are risk free when rebalanced continuously will frequently exhibit substantial systematic risk when rebalanced at finite intervals. This systematic risk may have biased important empirical tests of the option pricing model. Moreover, this systematic risk means that the Black-Scholes option pricing model is inherently inconsistent with the discrete time version of the Capital Asset Pricing Model (CAPM).

Type
Research Article
Copyright
Copyright © School of Business Administration, University of Washington 1990

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Baesel, J.; Shows, G.; and Thorp, E.. “The Cost of Liquidity Services in Listed Options: A Note.” Journal of Finance, 38 (06 1983), 889995.CrossRefGoogle Scholar
Bhattacharya, M.Transactions Data Tests of Efficiency of the Chicago Board Options Exchange.” Journal of Financial Economics, 12 (08. 1983), 161185.Google Scholar
Black, F., and Scholes, M.. “The Pricing of Options and Corporate Liabilities.” Journal of Political Economy, 81 (05 1973), 637654.CrossRefGoogle Scholar
Black, F., and Scholes, M.. “The Valuation of Option Contracts and a Test of Market Efficiency.” Journal of Finance, 27 (05 1972), 399417.CrossRefGoogle Scholar
Blomeyer, E., and Klemkosky, R.. “Tests of Market Efficiency for American Call Options.” In Option Pricing, Brenner, M., ed. Lexington, MA: D. C. Heath (1983), 101121.Google Scholar
Boyle, P., and Emanuel, D.. “Discretely Adjusted Option Hedges.” Journal of Financial Economics, 8 (09. 1980), 259282.CrossRefGoogle Scholar
Brennan, M.The Pricing of Contingent Claims in Discrete Time Models.” Journal of Finance, 34 (03 1979), 5368.Google Scholar
Castanias, R.; Chung, K.; and Johnson, H.. “Dividend Spreads.” Journal of Business, 61 (07 1988), 299319.Google Scholar
Chiras, D., and Manaster, S.. “The Information Content of Option Prices and a Test of Market Efficiency.” Journal of Financial Economics, 6 (06/09. 1978), 213234.CrossRefGoogle Scholar
Cox, J., and Rubinstein, M.. Option Markets. Englewood Cliffs, NJ: Prentince Hall (1985).Google Scholar
Duan, J. “Option Beta and Discretely Rebalanced Option Hedges.” Manuscript, McGill Univ. (1989).Google Scholar
Galai, D., and Masulis, R.. “The Option Pricing Model and the Risk Factor of Stock.” Journal of Financial Economics, 3 (01/03 1976), 5381.Google Scholar
Gilster, J. “The Systematic Risk of Discretely Rebalanced Option Hedges: A Misapplication of Ito's Lemma.” Unpubl. Manuscript, Michigan State Univ. (1989).Google Scholar
Gilster, J., and Lee, W.. “The Effects of Transaction Costs and Different Borrowing and Lending Rates on the Option Pricing Model.” Journal of Finance, 39 (09 1984), 12151221.CrossRefGoogle Scholar
Leland, H.Option Pricing and Replication with Transactions Costs.” Journal of Finance, 40 (12 1985), 12831301.Google Scholar
Longstaff, F.Temporal Aggregation and the Continuous-Time Capital Asset Pricing Model.” Journal of Finance, 44 (09 1989), 871888.Google Scholar
Omberg, E. “On the Theory of Perfect Hedging.” Manuscript, Santa Clara Univ. (08 1988).Google Scholar
Phillips, S., and Smith, C.. “Trading Costs for Listed Options.” Journal of Financial Economics, 8 (06 1980), 179201.Google Scholar
Rubinstein, M.The Valuation of Uncertain Income Streams and the Pricing of Options.” Bell Journal of Economics and Management Science, 7 (Autumn 1976), 407425.Google Scholar
Whaley, R.Valuation of American Call Options on Dividend Paying Stocks: Empirical Tests.” Journal of Financial Economics, 10 (03 1982), 2957.CrossRefGoogle Scholar