A0928
Title: A direct test of the fundamental assumption of option pricing models
Authors: Peter Moffatt - University of East Anglia (United Kingdom) [presenting]
Kensley Blaise - Bank of England (United Kingdom)
Anthony Rezitis - University of East Anglia (United Kingdom)
Abstract: The most fundamental assumption underlying option pricing models is that the market price of an option is equal to the discounted expected value of the final payoff. This assumption is tested directly with data on market prices of options combined with data on realised final payoffs. The data set contains around 1.5 million European options written on the S\&P500 index, between January 2022 and December 2023, with expiry dates ranging from January 2022 to July 2025. Only near-the-money options are included in the sample. The framework for testing the hypothesis of interest is a heteroscedastic regression model with discounted actual payoff at expiry as the dependent variable, and market price of the option as the independent variable. The joint hypothesis under test is essentially that the intercept is zero and the slope is one. This hypothesis is tested both parametrically and non-parametrically. As well as being tested for the entire sample, it is tested separately for call options and put options. It is also tested separately for bull-market phases and bear-market phases. The fundamental assumption is always strongly rejected, usually with the intercept being different from zero but the slope not being different from one. It is concluded that a useful way of judging the performance of an option pricing model is to compare computed option valuations to discounted final payoffs, rather than to market prices.
