Modelling Option Prices in Australia Using the Black-Scholes Model

Abstract

This paper provides evidence on the ability of the Black-Scholes model to price options traded on the Australian market. The only variable in the Black-Scholes model which is likely to be subject to significant measurement error is the standard deviation rate. Two different methods of estimation are examined here: historically-based and implied standard deviations. Using historical estimates of the standard deviation rates resulted in significant underpricing by the model relative to the market. This underpricing was consistent across in/out and short/long options with the latter proving particularly troublesome for the model. As would be expected, the use of weighted implied standard deviation (lagged one month), greatly improves the pricing ability of the model. Mean pricing differences were small in absolute terms and very few remained statistically significant.