You are on page 1of 17

Journal of Financial Economics 15 (1986) 341-357.

North-Holland

UNBIASED ESTIMATION OF THE BLACK/ SCHOLES


FORMULA*

J. S. BUTLER
Vunderhilt Uniuersi~y, Nushodle. TN 37203, USA

Barry SCHACHTER
SWIO~Fraser Unwersiry, Burnahy, B.C.. V5A I S6, Cunudu

Received July 1984, final version received June 1985

The Black/Scholes model gives the price of an option as a function of the true variance rate of the
underlying stock and other parameters. Because the true variance rate is unobservable, an estimate
of the variance rate is used in empirical tests. But, because the Black/Scholes formula is non-linear
in the variance, option price estimates using an estimated variance are biased, even if the variance
estimate itself is unbiased. This paper develops an unbiased estimator of the Black/Scholes
formula from a Taylor series expansion of the formula and the properties of the pdf of the
estimated variance.

1. Introduction

This paper presents an estimator of the Black and Scholes (1973) option
pricing formula that is free of the variance induced bias discussed by Thorp
(1976), Boyle and Ananthanarayanan (1977) and others. The estimator is
obtained by using a Taylor series expansion of the Black/Scholes formula and
the moments of the estimated variance rate. The new estimator permits a
clearer evaluation of the Black/Scholes model than has been available.
The Black/Scholes option pricing model gives the price of an option as a
function of the variance rate of the underlying stock and other parameters. The
model has been used to provide insights into many different theoretical
valuation problems in finance. However, there are serious estimation problems
associated with attempts to validate the model empirically. One major problem
is that an estimate of the variance rate, rather than the true variance rate must
be used in any test. Thorp (1976) and others have shown that estimates of
option prices using variance estimates are biased. This is true even if the

*We would like to acknowledge the useful comments of John Heaney, Clifford Smith, and the
referree, Steven Manaster.

0304-405X/86/$3.5001986, Elsevier Science Publishers B.V. (North-Holland)


342 J. S. Butler and B. Schachter, Unbiased estimation of the Black/Scholes form&

variance rate estimate itself is unbiased, because the Black/Scholes formula is


non-linear in the variance, and unbiasedness is not preserved under a non-
linear transformation.
In this paper we discuss a procedure for generating unbiased estimates of
Black/Scholes option prices. We first, in the next section, review in some detail
the problem of bias in the context of the existing literature. In section 3 we
discuss the properties of the usual historical variance estimate. Employing the
historical variance estimator, we construct the unbiased estimator in section 4.
The unbiased estimator is compared to other option price estimators in section
5. In section 6 we summarize the results and discuss some of their broader
implications.

2. Bias in testing the Black/&holes model

The following notation is used:

c = option exercise price,


X = current stock price,
r = riskless rate of return,
T = option time to maturity,
= true variance rate of the stock,
:5 = unbiased estimate of the variance rate,
= x/(c(exp( - rT))),
51 = (ln( g) + u*T)/2&,
d2 =dl-u@,
h(u2) = x@(dZ) - c(exp(-rT))@(d2),
W = market option price,
h(s*) = Black/Scholes option price using s2 instead of u2.

All the data necessary for testing the Black/Scholes model empirically is
observable except the variance rate of the underlying stock which must be
estimated. Thus, even if the Black/Scholes model were correct in the sense that
the market price of options is determined as if the true variance rate were
known, an investigator cannot directly test whether h( u2) = w. Because the
true variance rate is not known to the investigator, an estimated variance rate
is used in tests of the Black/Scholes model. But the use of an estimated
variance rate is a source of biased option price estimators. Using a numerical
analysis, Boyle and Ananthanarayanan (1977) have shown that E( h( s2)) #
h( u*). To see why this is so, h(s*) can be expanded around u2, the expectation
of s*. Doing so, we get

h(s*)=h(u*)+(S*-U*)h(U*)+(S*-u*)*h~$l*)/2. (1)
J. S. Butler and B. Schachter, Unbiased estimatron of the Black/Scholesjormula 343

Higher-order terms can be neglected as they are numerically small. Taking the
expectation of (1)

E(h(s2)) -h(u*) =var(.s2)h(u2)/2. (2)

The bias is a function of the variance of the variance estimate and the second
derivative of the Black/Scholes formula with respect to the variance. We can
be more precise about the nature of the bias by looking more closely at A( U ).
We can write

h(u2) =x[@(dl) - (l/g)@(d2)1, (3)

where the expression in brackets is bounded by 0.0 and 1.0. Hereafter, we work
with that expression. Substituting for h into eq. (2) gives

(4)

The pattern of the biases examined by Boyle and Ananthanarayanan (1977)


in their table 2 may be related to the behavior of a2@(di)/J(s2), i = 1.2,
over the range - co < di < 00. The second derivative of the standard normal
cdf is plotted in fig. 1. Boyle and Ananthanarayanan (1977) found that as the
stock price, and hence dl and d2, rises, a small positive bias reaches a
maximum, becomes a large negative bias, and then becomes positive again.
That pattern is reflected in fig 1.
There are three ways to deal with this variance-induced bias. We can try to
minimize the bias by reducing the variance of the variance estimate (usually
this would mean selecting a larger sample size). We can try to infer. the true
variance rate from the market price of the option. Finally, we can search for a
function, f(s2) such that E(f(s2)) = h(u2). The latter course of action has not
been pursued in the literature, and it is the method which we follow. Before we
proceed however, we briefly discuss the first two methods.
If the variance rate of a stock were constant, then we could make the
variance of an historical variance estimate arbitrarily small by selecting a large
enough sample. But even proponents of the Black/Scholes model might be
unwilling to argue that the variance rate of the underlying stock is constant
over a period much longer than that assumed in the model (i.e., the life of the
option). There is growing empirical evidence [see Christie (1982) for example]

Boyle and Ananthanarayanan (1977) emphasize percentage bias.


344 J. S. Burler and B. Schochter. U&used estimation of the Blrck/Scholes form&

The second derivative of


the standard normal
cdf, * (4

-3 -2 -1

Fig. 1. The behavior of the second derivative of the standard normal cumulative distribution
function over the range - 00 to + 00.

that the variance rate is not constant. Therefore, in general, the longer is the
time series of observations used to estimate the variance rate, the more biased
the variance estimate may be. As a result, using more data involves a tradeoff
between reducing the variance of the variance estimate and increasing its bias.
Examples of tests incorporating longer time series are those of Black and
&holes (1972) (one year of daily observations), Finnerty (1978) (eight years of
weekly observations), and Latane and Rendleman (1976) (four years of monthly
observations). We cannot determine the amount of bias induced by the use of
long time series without an analysis of the behavior of the variance rate.
An alternative way of reducing the variance of the estimate is to introduce
information other than close-to-close returns. Several authors have suggested
including the bid-ask spread, high, low, and opening prices [see for example,
Bhattacharya (1980), Garman and Klass (1980) and Parkinson (1980)]. How-
ever, unless there is a continuous sample path, these methods also introduce
bias into the variance estimate [see Marsh and Rosenfeld (1984) for a further
criticism]. Other alternative variance estimators may be employed which might
yield improved results as well. Ball and Torous (1984) suggest that the
maximum likelihood estimator (MLE) might be used. The MLE is invariant
under non-linear transformations, but it is only unbiased in the limit. Geske
and Roll (1984) suggest a Bayes/Stein estimator which explicitly adjusts the
J. S. Butler and B. Schachter, Unbrased estimation of the Bluck/Scholes form& 345

variance estimate to achieve better results. The Bayes/Stein estimator is itself


biased, and yields biased estimates of option prices, though with a lower mean
squared error than the usual estimator. Boyle and Ananthanarayanan (1977)
suggest a different Bayesian approach to reduce the variance of the variance
estimate. Their approach is sensitive to the choice of priors, and it is difficult to
determine the appropriate prior distribution.
The second method mentioned above which would circumvent the problem
of variance induced bias was developed by Latane and Rendleman (1976).
They obtain an estimate of the standard deviation [called an Implied Standard
Deviation (ISD)] by using the market price of an option and the Black/Scholes
formula to back out this unobservable parameter. If the Black/Scholes model
is correct in the sense that market prices are determined as if the true variance
rate were known, that is if h( u2) = w, then the ISD would be equal to the true
standard deviation, and there would be no variance-induced biases using ISDs.
However, the market price of an option used in any test will only on average
equal the correct Black/Scholes price, that is, we should write

w=h(u2)+e, (5)

where e is an error term with zero mean. There are several reasons why the
error term might not be zero. At the simplest level, the set of possible
transaction prices is not continuous. Thus the correct Black/Scholes price
might lie between two admissible transaction prices. Also, noise in the option
price process would: cause observed prices to deviate from equilibrium prices.
Data problems may result in a non-zero error term as well. For example, the
use of non-synchronous data may cause apparent deviations of observed prices
from correct prices.
However, perhaps the most compelling reason for the existence of an error
term is the fact that no investor in the market can know or use the true
variance rate in evaluating an option. Because of this, options will not be
priced as if the true variance rate were known. Even if all investors use an
unbiased estimate of the true variance rate, at any point in time their estimate
will equal the true rate with probability zero. This implies that the market
price, at a point in time, will equal the Black/Scholes theoretical price with
probability zero. However, in a rational market we should at least be willing to
assert that investors will be correct on average in estimating option prices.
Thus we have an error term with zero mean in eq. (5).
From eq. (5) it can easily be shown that an ISD will not equal the true
standard deviation of the underlying asset. If we take the inverse function of h,
denoted by h ~ ( w), and use a Taylor series to approximate of the right-hand
side of (5) we get

h-(w) =ISD= u + (X1( w))e + 0.5( h-( w))e2 + ... . (6)


346 J. S. Butler ond B. Schuchter, Unbiased estimution of the Black/Scholes formula

In general, the expectation of ISD will not equal u even if E(e) = 0. Some
previous research supports the idea of ISDs as biased. For example, Chiras and
Manaster (1978) have shown that their ISDs taken as a weighted average
explain more of the cross-sectional variation in future sample standard devi-
ations than does the historical standard deviation. Yet, even in their case their
ISDs are not unbiased guesses of the future sample standard deviations. If they
were, the slope in their regressions would equal one and the intercepts would
be zero which they were not.*
Under the assumptions above the ISD will not be unbiased, while the third
method of circumventing the problem of variance-induced bias to which we
now turn has the virtue of being unbiased by construction.3 The question
remains empirical whether there is greater potential for sampling error in
making some assumptions about e and estimating u based on a sample of
ISDs or, as we shall do below, in estimating the moments of s2.

3. Estimating d with the historical variance

The sampling distribution of the historical variance estimator is known and


it is the minimum variance unbiased estimator for the period over which the
variance rate may be constant. For these reasons we employ the historical
variance estimator in the unbiased estimator constructed in the next section.
The distribution of the variance estimator is discussed next.
Black and Scholes (1973) assume that the variance rate of the stock is a
constant (that is, the variance is a constant proportion of the square of the
stock price, p. 640). Therefore, the variance rate is estimated from a sample of
percentage changes in the stock price; s2 = (l/n)C[(x, - x,_,)/xf]. Accord-
ing to the Black/Scholes assumptions, the percentage change in the stock price
is distributed N(0, u). The sum of the squared percentage changes is distrib-
uted T(cu, A), (Y= n/2, h = n/(2u2). Boyle and Ananthanarayanan (1977)
describe s2 as being distributed &i-square. The &i-square density is a particu-
lar case of the gamma density [Mood, Graybill and Boes (1974)]. We can write
the pdf of s* as

g(.?) =[(q2uy2(s*)(- 2)2exp( -n/2u2)s]/r(n/2),

We would like to acknowledge the referee, Steven Manaster, for his suggestions which helped to
improve the clarity of this argument.
3An analysis of the exact biases in ISDs can be found in Butler and Schachter (1984a). Bias in
ISDs has important consequences for empirical work in other areas where ISDs are used. For
example, Manaster and Rendleman (1982) in examining the role of the option market as the
market of choice among investors use Jointly determined implied stock prices and ISDs. If as we
argue r is not always identically zero, then the biases suggested above may sneak into the work of
Manaster and Rendleman, affecting both their ISDs and implied stock prices. See Butler and
Schachter (1984b) for a more complete discussion.
J. S. Butler ond B. Schachter, Unbiased estimation of the Black/Scholes formulu 347

with mean and variance given by E(s2) = v2 and var(s2) = 2v4/n. The gamma
function, I3 n/2), is written, using Stirlings formula, as

r( n/2) = (n/2) exp(n/2)6(1 + 1/(6n))@. (8)

For greater accuracy, (72~)) and other terms can be added to (1 + 1/6n).
Substituting into the pdf gives

g(s2) = (ns2/2v),12exp(-n/2)exp( -ns2/2v2)Jn72


(9)
sfi(l + 1/(6n))

A few manipulations will facilitate the work of the next section. First define
t = s2/v2 so that

t-2/2exp( - n/2)exp( - nt/2)m


At) =
tfi(l + 1/(6n)) .
(10)

Multiplying by exp( t)exp( - t) (to facilitate the numerical integration) gives

exp(( n/2)(1 - t + nt) + t)Jn/2exp( - t)


At) =
tfi(1 + 1/(6n))
(11)

The pdf, in the form of (9) is used below to integrate numerically various
expectations and variances of functions of the estimated variance.

4. An unbiased estimator of the option price

We cannot insert the estimated variance in the Black/Scholes formula to get


unbiased estimates of the option price, because the formula is non-linear. The
non-linearity arises from the standard normal cdf. To circumvent this problem,
we first expand the h( v2) in a Taylor series. We can express the standard
normal cdf as a polynomial to arbitrary accuracy (many terms are needed in
practice). We expand the cdf around zero. We cannot expand around the true
variance rate because it is not known in practice. The resulting terms can be
rewritten as constants (in fact, power series in g) multiplied by half integral
powers of s2. That is, each term is linear in a power of s2. We know that were
we to insert the estimated variance rate for the true variance rate into the
Black/Scholes formula we would obtain a biased estimator. Inserting the
estimated variance rate into the expansion of the formula must also yield a
biased estimator (the terms are non-linear in the estimated variance rate).

JCC C
348 J. S. Butler and B. Schachter, Unbiased estimation of the Black/Scholes formulu

However, because the terms in the expansion are linear in powers (moments)
of s*, we can avoid any bias by inserting instead unbiased estimators of the
various powers of S* into the expression. All such powers of s2 (except
negative integers) give rise to calculable minimum variance unbiased estima-
tors. The estimators are functions of s2. The resulting expression is sum of a
set of terms linear in the stochastic element of each term, and is therefore an
unbiased estimator of h (u*).
To be more concrete, write the standard normal cdf as

Q(d) = G(o) +d@(O) + (d*/2)@(0) + (d3/6)P(0) + ... . (12)

But, a@(d)/ad = 0, at d = 0, for even n > 0, because an@(d)/adn is a


polynomial in d times +(d), including a constant only when n is odd. Note
that @= +, the pdf, so @ = +- . An even derivative of @ is an odd
derivative of (p. Thus

Q(d) = Q(O) +dqb(O) + (d3/6)$(0) + (d/120)+~(0) + ... . (13)

But,

Q(O) = +,

0) = -ao~
G(0) = 39(o),

G*(O) = (-1). 1 .3 . . . (2i - l)+(O).

Therefore, we may write

@(d)=+++(O)(d-d3/6+d5/40- . ..). (14)

where the ith term in the expression multiplying ~(0) is

( - l)-l. d*-l. $. $ . . * (1/(2i - 2)) . (1/(2i - 1)).

Substituting for dl and d2 and collecting terms in powers of U* yields


expressions involving half integral powers of v2 (i.e., odd powers of u). We can
generate unbiased estimates of these from s2 by using the moments of s*:

E((s~)) = 2T(k,2+j)(u2)/r(k,2), (15)

where k is the number of degrees of freedom in estimating .T* [see Mood,


J. S. Butler and B. Schachter, Unbiased estimation of the Black/Scholes formula 349

Graybill and Boes (1974, p. 541)]. The gamma function is defined for all real
numbers except negative integers, so E(s*)J is not defined for negative integral
values of j. Fortunately, they are not needed here. The expansion of @
converges slowly, yet any degree of accuracy is obtainable by using a sufficient
number of terms in the expansion. The resulting expression is not as elegant as
the Black/Scholes formula using s2 or ISD, but it is an unbiased estimator. An
illustration of the construction of the estimator, using the terms up to that
containing d 3, is in the appendix.

5. Comparative performance of option price estimators

There may exist other unbiased estimators of h( u2), but they are not known.
It is possible to estimate h(u2) by maximum likelihood from a sample of
option prices, but this estimate is only asymptotically unbiased. Numerical
investigation reveals substantial bias in realistic sample sizes. h( s2) is also
asymptotically unbiased. But the sample size consistent with stationarity of the
variance rate is likely to be too small for asymptotic unbiasedness to hold.
Thus, the unbiased option price estimator developed in the previous section is
the only available unbiased estimator.
Even if there were other unbiased estimators available, this one is the
minimum variance unbiased (MVU) estimator. To see this designate the Taylor
expansion of h(u*) as A(u*). A is a polynomial in u. The MVU estimator of
UJ is C,sJ [where C, is an appropriate constant, see (13)], because s is estimated
using sufficient statistics for u and E(sJ) = C,uJ. The maximum likelihood
(ML) estimator of UJ is sJ. If an unbiased estimator which is a function of the
ML estimator exists, it is the MVU estimator [see Rao (1973, p. 321)].
Therefore, C,sJ is the MVU estimator of uJ. Consequently, &,CJsJ is the
MVU estimator for col,uJ, where 1y is a weight. Because A = caJcJ, &,C,sJ
is the MVU estimator for A, and thus h(u).
The biasedness of an estimator does not imply that its mean squared error
(MSE) cannot be lower than that of the estimator developed here. However,
this question can only be addressed numerically, as there is no analytical
expression for the pdf of h(s2). Note, however, an estimator with a universally
minimum MSE is very rare [Mood, Graybill and Boes (1974)].
In table 1 95% confidence intervals for Black/Scholes option price estimates
are shown for options out of, at, and in the money.4 The confidence intervals
are given as a percentage of the theoretical Black/Scholes value. The con-
fidence intervals are obtained by first calculating the confidence interval for the
estimated variance rate given the appropriate parameters of the gamma distri-
bution. The endpoints are then inserted into the Black/Scholes formula to

% our terminology, an option is defined as out, at. or in the money as the ratio of the stock
price to the present value of the exercise price is less than, equal to, or greater than one.
350 J. S. Butler and B. Schachter, Unbiased estrmation of the Black/Scholes formula

Table 1
Width of 95% confidence intervals for the usual Black/Scholes option price estimate expressed as a
percentage of the theoretical Black/Scholes value.

Ratio of stock price to present value of exercise price


Trueh Degrees of
variance freedom 0.8 1.0 1.2

0.01 60 277.710 35.656 1.476


180 152.478 20.756 0.841
250 129.495 17.585 0.715
0.02 60 166.240 35.626 4.570
180 95.590 20.738 2.657
250 81.607 17.570 2.260
0.03 60 131.285 35.596 7.134
180 76.342 20.721 4.161
250 64.919 17.555 3.535
0.04 60 113.303 35.565 9.157
120 66.032 20.704 5.342
180 56.116 17.541 4.536

The confidence interval is obtained from the confidence interval for the variance rate (given the
true variance rate and degrees of freedom) by evaluating the Black/Scholes formula at the
endpoints of the confidence interval of the variance rate.
hThis is the variance till maturity, o*T.
This refers to the number of degrees of freedom assumed in the estimate of the variance rate.

generate the confidence intervals shown. Variances of 0.01 to 0.04 and degrees
of freedom of 60, 180 and 250 (representing 3, 9 and 12 months of daily data)
are used. The confidence intervals shrink as the sample size increases, because
the estimate of the variance rate becomes more precise as the sample size
increases. They are absolutely widest for options at the money. As a percentage
of the true option value, they are extremely wide for options out of the money.
At the money options have confidence intervals that are virtually constant in
proportional width, depending on the degrees of freedom. Confidence intervals
for in the money options are proportionally narrower, but usually a few
percentage points of the true option value. Interestingly, as the variance
increases, confidence intervals change in proportion to the true option value by
growing (if in the money), remaining constant (if at the money), or shrinking
(if out of the money). These results suggest that considerable variation in
option price estimates derived from the Black/&holes model can be attributed
to the variance estimate. Any examination of too limited a range of parameter
values is apt to lead to misleading results concerning the nature of the variance
induced bias.
Tables 2 and 3 compare the biases found in the unbiased estimator and the
usual estimator of the Black/Scholes formula (with an estimated variance
inserted directly into the formula). In these and the following tables we are of
course assuming that we know the correct Black/Scholes price. Because these
Table 2
Biases in the unbiased estimator of the Black/Scholes option price using an unbiased variance estimate
-______
Ratio of stock price to present value of exercise price
0.X 1.0 1.2

Trueh Degrees of Absoluted Percentage Absoluted Percentage Absoluted Percentage


variance freedom bias bias bias bias bias bias
.~~
0.01 60 ~ 0.9375E-09 ~ O.l879E-05 0.6085E-17 O.l526E-15 ~ 0.5089E-09 0.3031E-08
180 O.l390E-10 0.2786E-07 O.l298E-16 0.3256E-15 ~ 0.3978E-12 ~0.2369E-11
250 O.l390E-10 0.2786E-07 0.2006E-16 0.5030E-15 mm0.3987E-12 - 0.2369E-11
0.02 60 - 0.7440E-13 pO.l925E-10 O.l247E-16 0.2212E-15 ~0.4330E-13 ~ 0.2508E-12
180 - 0.2097E-14 - 0.5426E-12 0.2212E-16 0.3924E-15 O.Y536E-16 0.5522E-15
250 -0.2069E-14 - 0.5356E-12 0.3224E-16 0.5719E-15 O.l134E-15 0.6565E-15
0.03 60 pO.l992E-15 ~0.2210E-13 O.l236E-16 O.l791E-15 pO.l673E-15 -0.9373E-15
180 0.6916E-16 0.7672E-14 0.242OE-16 0.3507E-15 0.2754E-16 O.l524E-15
250 0.9650E-16 O.l070E-13 0.3654E-16 0.5294E-15 0.4619E-16 0.2587E-15
0.04 60 -O.l3OOE-16 ~ 0.8767E-15 0.2960E-16 0.3716E-15 0.3280E-16 O.l775E-15
120 O.l287E-16 0.8685E-15 0.4342E- 16 0.5451E-15 0 5275E-16 0.2858E-15
250 0.4108E-16 0.277lE-14 0.5768E-16 0.724lE-15 0.7264E-16 0.3936E-15

Biases are calculated by numerically evaluating the pdf of the unbiased option price estimator. The pdf of the option price estimator is a function of
the moments of the variance estimator.
hThis is the variance till maturity r)*T.
This refers to the number of degrees of freedom assumed in the variance rate estimate.
dOption prices are based on an option to purchase one share of stock with a price of $1.
Table 3
Biases in the usual estimator of the Black/Scholes option price using an unbiased variance estimate.

RatCo of stock price to present value of exercise price


0.8 1.0 1.2
._
Trueh Degrees of Absolute Percentage Absoluted Percentage Absolut@ Percentage
variance freedom bias bias bias bias bias bias

0.01 60 0.9685E-04 0.1196 -O.l161E-03 - 0.4165E-02 0.6523E-04 0.3885E-03


180 0.2023E-04 0.4055E-01 ~ 0.5544E-02 ~ O.l390E-02 0.2208E-04 O.l315E-03
250 O.l460E-04 0.2925E-01 - 0.3992E-04 -O.lOllE-02 O.l593E-04 0.9490E-04
0.02 60 O.l103E-03 0.2855E-01 - 0.2352E-03 - 0.4172E-02 0.6130E-04 0.3550E-33
180 0.3717E-04 0.9620E-02 ~ 0.785OE-04 ~ O.l393E-02 0.2043E-04 O.l183E-03
250 0,2680E-04 0.5936E-02 ~ 0.5653E-04 ~ O.l003E-02 O.l471E-04 0.8519E-04
0.03 60 0.9128E-04 O.l918E-01 ~ 0,2884E-03 ~ 0.4178E-02 O.l661E-04 0,9301E-04
180 0.3042E-04 0.3375E-02 ~ 0,9626E-04 - O.l395E-02 0.5212E-05 0.2919E-04
250 0.2190E-04 0.2430E-02 ~ 0.6932E-04 - O.l004E-02 0.3719E-05 0.2083E-04
0.04 60 0.4823E-04 0.3253E-02 -0.3334E-03 - 0.4185E-02 0.3333E-04 O.l806E-03
120 O.l572E-04 O.l061E-02 -O.l113E-03 - O.l397E-02 O.l163E-04 0.6299E-04
250 O.l128E-04 0.7612E-03 ~ 0.8014E-04 - O.l006E-02 0.8424E-05 0.4564E-04

Biases are calculated by numerically evaluating the pdf of the usual Black/Scholes option price estimator. that is. the Black/Scholes formula with a
variance estimate inserted in place of the unknown true variance. The pdf of the option price estimator is a function of the moments of the variance
estimator.
This is the variance till maturity 0~7.
This refers to the number of degrees of freedom assumed in the variance estimate.
d Option prices are based on an option to purchase one share of stock with a price of $1.
Table 4
Root mean square errors in the unbiased and usual Black/Scholes option price estimates.
_...- _____
Ratio of stock price to present value of exercise price
0.8 1.0 1.2

Trueh Degrees ofC Unbiased Usual Unbiased Usual Unbiased Usual


variance freedom estimator estimator estimator estimator estimator estimator

0.01 60 0.3479E-03 0.3705E-03 0.3645E-02 0.3633E-02 0.6370E-03 0.6485E-03


180 O.l968E-03 0.2015E-03 0.2014E-02 O.l781E-02 0.3651E-03 0.3109E-03
250 O.l664E-03 O.l694E-03 O.l783E-02 O.l781E-02 0.3095E-03 0.3109E-03
0.02 60 O.l662E-02 O.l667E-02 0.5148E-02 0.5132E-02 0.2033E-02 0.2033E-02
180 0.9565E-03 0.2966E-02 0.296%02 0.2965E-02 O.l180E-02 O.l774E-02
250 0.8119E-03 O.X119E-03 0.2518E-02 0.2516E-02 O.lCOlE-02 0.9996E-03
0.03 60 0.3067E-02 0.3049E-02 0.2974E-03 0.6277E-02 0.3297E-02 0.3270E-02
180 O.l770E-02 O.l766E-02 0.3631E-02 0.3627E-02 O.l903E-02 O.l898E-02
250 0.1501E-02 O.l499E-02 0.3080E-02 0.3078E-02 0.1615E-02 O.l618E-02
0.04 60 0,4343E-02 0.4314E-02 0.7263E-02 0.7239E-02 0.4367E-02 0.4331E-02
120 0.2511E-02 0.2504E-02 0.4187E-02 0.4183E-02 0.2521 E-02 0.2514E-02
250 0.2130E-02 0.2126E-02 0.3552E-02 0.3550E-02 0.2139E-02 0.2135E-02

The mean square error is the sum of the squared bias of the estimator and the estimators variance.
b This is the variance till maturity PT.
This refers to the number of degrees of freedom in the variance estimate.
354 J. S. Butler und B. Schachter, Unhiawd estimation of the Biuck/Scholes formula

tests of performance are done from simulations and not actual data, the results
are correct only under the maintained assumptions. The robustness of the
results to the actual data is an important consideration for the practical success
of the procedure. The tests simulated might not be very powerful in practice
given the assumption that true Black/Scholes prices are never actually seen.
We are currently investigating the performance of the unbiased estimator with
actual data [Butler and Schachter (1984c)]. However, the results are as yet quite
tentative, and tht& will be reported in a later paper.
Table 2 shows that the unbiased estimator is indeed unbiased. Its errors are
largest when the true variance is small and the option is not at the money.
However, the maximum bias is less than lo-. Table 3 shows the bias in the
usual estimator is many orders of magnitude greater than the unbiased
estimator. The bias falls as the sample size increases. The bias usually rises
with the true variance, but not always. For in the money options, the bias
shows no consistent pattern. On average, the bias is on the order of $0.33 on a
contract to purchase 100 shares of a stock with a price of $50. The absolute
bias is greatest for options at the money, with an average bias of $0.67 on a
similar contract. Because, the majority of options traded are near the money,
the larger figure is more representative. The bias averages about 2.2% of option
price.
Table 4 compares the root MSE of the usual estimator and the unbiased
estimator. When the option is out of the money and the variance is small, the
unbiased estimator is smaller in root MSE. Otherwise, the root MSE of the
usual estimator is consistently higher by one percent or less. The root MSE
rises with the variance and is highest for options at the money.

6. Summary

We have derived an unbiased estimator for the Black/Scholes option price


using a Taylor series expansion of the standard normal cdf and the distribution
of the MVU estimator of the variance rate. We have compared the perfor-
mance of the unbiased estimator with the usual estimator. While the unbiased
estimator performs better on the whole, based upon the simulations, an
empirical test is necessary. The authors are currently working on such a test
[Butler and Schachter (1984c)]. The unbiased estimator may provide researchers
with a better means of attempting to validate the Black/Scholes (and, by
extension, any other) option pricing model.
The results developed here should be important for the practitioner as well.
For example, variance-induced bias causes the usual estimator to misidentify
over- and underpriced options. Improved performance may accompany use of
the unbiased estimator.
The unbiased estimator does not solve all problems related to the determina-
tion of Black/Scholes option prices. There are several well-known data prob-
J. S. Butler nnd B. Schuchter, Unhm.ved esrimution of the Bluck/Scholes formula 355

lems which persist in confounding attempts to validate the model, e.g., the
bid-ask spread [Phillips and Smith (1980)] and non-synchronous data [Galai
(1978)]. Neither does the unbiased estimator address problems with model
misspecification: jumps [Merton (1976) Cox and Ross (1976) Jones (1984)],
dividends [Roll (1977) Geske (1979) Whaley (1981,1982)], non-stationarities
in the variance from leverage [Geske (1979) Christie (1982)], non-stationarities
in the variance from predictable events [Patell and Wolfson (1979) Whaley
and Cheung (1982)]. Nevertheless, the elimination of the variance-induced
biases in option price estimates is essential to construct a valid test of the
Black/Scholes model (or any model non-linear in the variance), not only
because of the magnitude of the biases but also because of their systematic
nature. For example, tests seeking to compare the performance of alternative
option pricing models may be misleading without accounting for the possibility
that variance-induced biases will affect the competing models differently be-
cause of the different non-linear transformations involved.

Appendix

This appendix explicitly develops the first few terms of the Taylor series
expansion used to generate the unbiased estimator of the Black/Scholes
formula. Setting T = 1, the Black/Scholes formula is restated as

h(u2)=@(ln(g)/u+u/2)-(l/g)@(ln(g)/u-u/2). (A.1 >

Each cdf is restated using the Taylor series in eq. (13):

Q(d) = Q(O) + d+(O) + d39(0)/6 + .... (A.2)

Using the following substitutions:

o(O)=+, $(0)=1/&Y, d=ln(g)/u+u/2,


(A.3)
G(O) =.-G(O), V(O) = 3@(O),

we get the expression

- b(s>/u - u/2)/6]]. (A.4)


356 J. S. Butler und B. Schachrer, Unhrused e.rsrimurrotl of rhe Blue X / Schole~ jormrrlu

Rearranging terms,

h( CI) = ;+ (l/&)[ln( g)/u+ u/2 - (ln(&/6~?

- (In( g))/4u - ln( g)o/8 - rj3/48]

- (l/g)[ f+ (l/fi)[ln(g)/~- u/2- (III(<~))~/~o

+ (ln( g))/4u - ln( g) u/8 + ~1/48]]. (A.51

Next, terms are collected in powers of u. Only odd powers appear because only
odd powers of (In (g)/o + u/2) are associated with non-zero coefficients in the
Taylor expansion of @.

I+) =;(l -l/g)+ (l/&+ ((ln(g))/6g- (ln(&6)

+ ~~~+(g)(l - l/g) - (ln(g)J2/4- (hM)/4,~)

+o(:-ln(g)/8+1/21:+ln(~)/8g)

- u3(1/48 + 1/48g)]. (A.61

To obtain unbiased estimators of the jth power (j being half of an odd


integer), use not s, but 3 divided by

(2r(k/2 +j)/I(k/2)), (A.7)

k being the number of degrees of freedom in estimating the variance rate. The
gamma function can be calculated iteratively based on r( 1) = fi. I( 1) = 1
and I(p) = (p - 1)1( p - 1). The factors in (A.7) become quite large rather
quickly. Only for j = : is the factor less than one.
Plugging the variance rate estimate directly into the Black/Scholes formula
is equivalent to omitting the factors in (A.7). Using (A.7) gives an unbiased
estimator.

References
Ball. C. and W. Torous. 1984. The maximum likelihood estimation of accurity price volatility:
Theory. evidence. and application to option pricing, Journal of Business 57. 97 112.
Black. F.. 1975. Fact and fancy in the use of options. Financial Analvsts Journal 31. 30 -72.
Black. F. and M. Scholes. 1973. The pricing of options and corporate liabilities. Journal of Political
Economy Xl, 637-659.
Black. F. and M. Scholes. lY72. The valuation of option conlracfs: A test of market cHicicncy.
Journal of Finance 27. 399-418.
J. S. Butler and B. Schachter, Unhrused estintaimn of the B&k/ Scholes fornulu 351

Bhattacharya, M., 1980, Empirical properties of the Black-Scholes formula under ideal conditions.
Journal of Financial and Quantitative Analysis 15, 1081-1105.
Boyle, P. and A. Ananthanarayanan. 1977, The impact of variance estimation in option valuation
models, Journal of Financial Economics 5, 357-387.
Butler, J. S. and B. Schachter, 1984a, The exact biases in implied standard deviations, Unpublished
working paper.
Butler. J. S. and B. Schachter. 1984b, A note on the use of implied stock prices. Unpublished
working paper.
Butler. J. S. and B. Schachter. 1984~. Testing the Black-Scholes model without bias. Unpublished
wjorking paper.
Chiras. D. and S. Manaster, 1978, The informational content of option prices and a test of market
cthciency. Journal of Financial Economics 6. 213-234.
Christic. A., 1982. The stochastic behavior of common stock variances, Journal of Financial
Economics 10. 407-432.
Cox. J. and S. Ross, 1976, The valuation of options for alternative stochastic processes, Journal of
Financial Economics 3. 145-166.
Finnerty. J.. 1978, The Chicago Board Options Exchange and market efficiency. Journal of
Financial and Quantitative Analysis 13. 29-38.
<i&u, D.. 197X. Empirical tests of boundary conditions for CBOE options, Journal of Financial
Economics 6. 187-212.
Garman, M. and M. Klass, 1980, On the estimation of security price volatilities from historical
data, Journal of Business 53, 67-78.
<;eske, R.. 1979, A note on an analytical valuation formula for unprotected American call options
on stocks with known dividends, Journal of Financial Economics 7. 375-380.
Gcskc. R.. 1979, The valuation of compound options, Journal of Financial Economics 7, 63-82.
Cieske. R. and R. Roll, 1984, Isolating the observed biases in American call option pricing: An
alternative variance estimator. Unpublished working paper.
Jones, E.. 1984. Option arbitrage and strategy with large price changes, Journal of Financial
Economics 13, 91-113.
Latane. H. and R. Rendleman, 1976, Standard deviations of stock price ratios implied in option
prices, Journal of Finance 31, 369-381.
Manaster. S. and R. Rendleman. 1982, Option prices as predictors of equilibrium stock prices,
Journal of Finance 37, 1943-105X.
Marsh. T. and E. Rosenfeld. 1984. Nontrading and estimates of stock price volatility. Unpublished
working paper (Sloan School of Management. MIT. Cambridge, MA).
Merton. R., 1976, The impact on option pricing of specification error in the underlying stock price
returns, Journal of Finance 31. 333-350.
Mood. A., F. Graybill and D. Boes. 1974. Introduction to the theory of statistics, 3rd ed.
(McGraw-Hill. New York).
Parkinson, M., 1980, The extreme value method for estimating the variance of the rate of return,
Journal of Business 53, 61-65.
Patell. J. and M. Wolfson. 1979. Anticipated information releases rctlected in call option prices,
Journal of Accounting and Economics 1, 1177140.
Phillips, S. and C. Smith, 1980, Trading costs for listed options: The implications for market
ethciency. Journal of Financial Economics 8, 179-201.
Rao. C., 1973, Linear statistical inference and its applications, 2nd ed. (Wiley, New York).
Roll, R.. 1977, An analytic valuation formula for unprotected American call opttons on stocks with
known dividends. Journal of Financial Economics 5, 251-258.
Thorp, E.. 1976, Common stock volatilities in option formulas. Proceedings of the Seminar on the
Analysis of Security Prices 2. 235-276.
Whaley. R.. 1981. On the valuation of American call options on stocks with known dividends.
Journal of Financial Economics 9. 207-211.
Whaley, R.. 1982, Valuation of American call options on dividend-paying stocks: Empirical tests,
Journal of Financial Economics 10. 29-5X.
Whaley, R. and J. Cheung. 1982, Anticipation of quarterly earnings announcements: A test of
option market efficiency, Journal of Accounting and Economics 4. 57-83.