Option Pricing and Momentum

J.C. Rodriguez

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Abstract

If managers are reluctant to fully adjust dividends to changes in earnings, stock returns and changes in the dividend yield will tend to be negatively correlated. When this is the case, stock returns will exhibit positive autocorrelation, or mo- mentum. This paper studies the pricing of options in such a situation, within a new model in which the dividend yield is an a¢ ne function of past stock returns. The model accommodates momentum in stock returns under complete markets, and, moreover, it renders preference-free formulas for European options. A momentum- inducing dividend yield implies that calls will be overpriced (underpriced) relative to puts after stock price increases (declines), a prediction in line with the findings of recent empirical research in finance, and that the Black-Scholes formula with constant dividend yield underprices out-of-the money options.
Original languageEnglish
Place of PublicationTilburg
PublisherFinance
Number of pages27
Volume2007-93
Publication statusPublished - 2007

Publication series

NameCentER Discussion Paper
Volume2007-93

Keywords

  • Options
  • Momentum
  • Stochastic convenience yield

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