Options are tradable financial instruments that give holders the right, but not the obligation, to buy or sell the underlying asset at a specific price at or before a certain future date. The classic mathematical model used to price an option is the Black-Scholes option pricing model. If stock markets are considered efficient, then prices must reflect all available information. However, past research suggests there is a degree of inefficiency in the market. This study investigates the impact of information obtained from the Black-Scholes option pricing model on the efficiency of the underlying stock market. Specifically, the hypotheses is that the implied volatility measure of the underlying stock's returns obtained from the Black-Scholes model is a better predictor of the bid-ask spread of a stock than the historical variance of returns measure; thus the former can be used to explain improved efficiency in the underlying stock market. Data for this study are collected from Yahoo Finance for a total of 100 firms. The results suggest that the model with the implied volatility measure is a better fit, and is more efficient in predicting the bid-ask spread of the underlying stock's returns than the model with the historical standard deviation of returns measure. Thus, this study suggests that the Black-Scholes model can be used add information that improves efficiency in the underlying stock market and further, the existence of an options market is, in general, beneficial for the quality of the underlying stock market.
Business Economics; Mathematics
Kumbhani, Sanjana, "The Black-Scholes Option Pricing Model and a Test for Efficiency in the Underlying Stock Market" (2017). Senior Independent Study Theses. Paper 7775.
Economics | Finance | Mathematics
Bachelor of Arts
Senior Independent Study Thesis
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