AN EMPIRICAL STUDY OF THE BLACK-SCHOLES OPTION PRICING MODEL AND EQUITY OPTIONS OF THE STOCK EXCHANGE OF SINGAPORE

Abstract

Stock options trading was re-introduced in Singapore in March 1993 after a failed introduction 14 years ago. Among the reasons cited for the demise of the stock options market previously was the lack of understanding by investors. Of fundamental importance to the understanding by investors and to the efficient development of stock options trading is the concept of the valuation/pricing of options. The Black-Scholes Option Pricing Model (and its variants) by virtue of its computational simplicity is widely used by option-market participants. This study thus studies how model prices predicted by the Black-Scholes Option Pricing Model have compared to the market prices for call options on the Stock Exchange of Singapore. Both parametric as well as non-parametric tests are used in the study. The findings are that generally, the Black-Scholes predicted prices are significantly higher than the observed market prices for the call options. This finding remains even when the data sample is segmented by time to maturity as well as moneyness. This result also holds regardless of whether implied volatilities or historical variances are use as input in the model. The use of a historical variance of 75 days (annualised on the basis of "trading-day") in the computation of the model prices appears, on the average, to price the call options the nearest to the observed market prices. The extent of overpricing also appears to become less nearing maturity. The observed overpricing bias of the BlackScholes Option Pricing Model could have been caused by non-synchronous trading during the period studied.