The effects of transaction costs and different borrowing and lending rates on the option pricing model / BEBR No.874

Includes bibliographical references (p. 26).This paper solves a stochastic differential equation to demonstrate that the market imperfections of transaction costs and different borrowing and lending rates partially offset each other to yield a range of equilibrium prices for an option. The Black-Scholes model price is shown to be in the lower portion of, or entirely below, the equilibrium range. These observations are used to explain several of the mythical anomalies found in the option pricing literature. The paper also points out that under some conditions there may be NO equilibrium option price. Instead there may be a bounded disequilibrium within which a single option will offer a risk free return above the Treasury bill rate, while SIMULTANEOUSLY permitting borrowing below the borrowing rate