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Rev Fin 1995; 8:1091-1124
© 1995 the Society for Financial Studies

Article

Option pricing and the martingale restriction

FA Longstaff
Anderson Graduate School of Management, UCLA, 405 Hilgard Avenue, Los Angeles, CA 90095, USA

Abstract

In the absence of frictions, the value of the under-lying asset implied by option prices must equal its actual market value. With frictions, however, this requirement need not hold. Using S&P 100 index options data, I find that the implied cost of the index is significantly higher in the options market than in the stock market, and is directly related to measures of transaction costs and liquidity. I show that the Black-Scholes model has strong bid-ask spread, trading volume, and open interest biases. Option pricing models that relax the martingale restriction perform significantly better.


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