Theory of Rational Option Pricing
Robert Merton ()
Bell Journal of Economics, 1973, vol. 4, issue 1, 141-183
The long history of the theory of option pricing began in 1900 when the French mathematician Louis Bachelier deduced an option pricing formula based on the assumption that stock prices follow a Brownian motion with zero drift. Since that time, numerous researchers have contributed to the theory. The present paper begins by deducing a set of restrictions on option pricing formulas from the assumption that investors prefer more to less. These restrictions are necessary conditions for a formula to be consistent with a rational pricing theory. Attention is given to the problems created when dividends are paid on the underlying common stock and when the terms of the option contract can be changed explicitly by a change in exercise price or implicitly by a shift in the investment or capital structure policy of the firm. Since the deduced restrictions are not sufficient to uniquely determine an option pricing formula, additional assumptions are introduced to examine and extend the seminal Black-Scholes theory of option pricing. Explicit formulas for pricing both call and put options as well as for warrants and the new "down-and-out" option are derived. The effects of dividends and call provisions on the warrant price are examined. The possibilities for further extension of the theory to the pricing of corporate liabilities are discussed.
References: Add references at CitEc
Citations: View citations in EconPapers (1850) Track citations by RSS feed
Downloads: (external link)
http://links.jstor.org/sici?sici=0005-8556%2819732 ... O%3B2-0&origin=repec full text (application/pdf)
Access to full text is restricted to JSTOR subscribers. See http://www.jstor.org for details.
Chapter: Theory of rational option pricing (2005)
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
Persistent link: https://EconPapers.repec.org/RePEc:rje:bellje:v:4:y:1973:i:spring:p:141-183
Ordering information: This journal article can be ordered from
https://editorialexp ... i-bin/rje_online.cgi
Access Statistics for this article
More articles in Bell Journal of Economics from The RAND Corporation
Bibliographic data for series maintained by ().