Tests of the black scholes option pricing model

Black and Scholes developed the first Option Pricing Model based on observable variables. This model was subsequently extended by Merton, Cox and Ross, Schwartz and others. In the past, empirical studies using the Black-Scholes option pricing model have obtained fairly satisfactory results. However, these tests have either assumed that discrete hedging will not significantly affect the results in any way or that it causes uncertain returns which could be diversified away. This paper shows that the use of discrete hedging will result in a significant bias in the excess returns. As such a bias is shown to be a function of the distribution of the rate of return on the stock, there is a possibility that the covariance between the excess return on a hedged position and that of the market are not zero. This implies the existence of systematic risk which could not be diversified away. Tests of the Montreal Stock Exchange's option market were also carried out. These tests were subjected to certain statistical problems as assumptions of the regression model used were violated. Despite these violations, the results indicate that profit opportunities do exist in the market. However, it is doubtful that such profit opportunities would still exist if transaction costs etc. are taken into consideration.Business, Sauder School ofGraduat