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Tests of an American Option Pricing Model on the Foreign Currency Options Market

Published online by Cambridge University Press:  06 April 2009

James N. Bodurtha Jr  and
Georges R. Courtadon
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Abstract

This paper tests the ability of the American option pricing model proposed by Parkinson [18] or Mason [14] to explain the pricing of the foreign currency options traded on the Philadelphia Stock Exchange from February 28, 1983 to March 26, 1985. We find that the model underprices out-of-the-money options relative to at-the-money and in-the-money options. This relative underpricing is driven by an underpricing of out-of-the-money call options of short maturity. In addition, the degree of relative mispricing for most categories of options is shown to be a decreasing function of the time to maturity of the options. Longer maturity options appear to trade at similar levels of implied volatility whether they are in, at, or out of the money. Most of these biases appear consistent with the fact that the underlying spot currency rate follows a mixed jump diffusion process as described in [17].

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 22 , Issue 2 , June 1987 , pp. 153 - 167
Copyright
Copyright © School of Business Administration, University of Washington 1987

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References

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