Quasi Mean Reversion in an Efficient Stock Market: The Characterisation of Economic Equilibria which Support Black-Scholes Option Pricing

Stewart Hodges and Andrew Carverhill

Economic Journal, 1993, vol. 103, issue 417, 395-405

Abstract: This paper is concerned with the behavior of the risk premium on the market portfolio of risky assets. The paper provides a characterization of the evolution of the market risk prem ium in economies where the variance of the return on the market has constant variance and market index options can be priced using the 1 973 Black Scholes model. It is shown that the risk premium satisfies a n on linear partial differential equation called Burgers' equation. The analysis has potentially important implications for empirical work, where for example, it is undecided whether observed mean reversion i n stock prices can be explained by time varying risk premia within an efficient market. Copyright 1993 by Royal Economic Society.

Date: 1993
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