Menachem Brenner, Young Ho Eom
ABSTRACT
The no-arbitrage approach to option pricing implies that risk-neutral
prices follow a martingale. The validity of this property has been tested
and rejected by Longstaff (1995). Since he tested the general framework,
his results have far reaching and disturbing implications for contingent
claims pricing. This paper proposes a new method to test the martingale
property. This method is based on the Laguerre polynomial series. The tests
use options and futures on the S&P 500 index. The new methodology and
data show that the martingale property cannot be rejected. This result
implies that the general approach is still valid and the existence of frictions
only adds noise. Testing more specific pricing models is relevant again.
Subject: Investment/Derivatives (Empirical)
Brenner: (212) 998-0323 mbrenner@stern.nyu.edu
Eom: (212) 720-1659 Youngho.Eom@frbny.sprint.co
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