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You are on page 1of 17

North-Holland

FORMULA*

J. S. BUTLER

Vunderhilt Uniuersi~y, Nushodle. TN 37203, USA

Barry SCHACHTER

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

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.

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

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.

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)

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

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)

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]

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

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

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

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.

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

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

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

Substituting into the pdf gives

(9)

sfi(l + 1/(6n))

A few manipulations will facilitate the work of the next section. First define

t = s2/v2 so that

At) =

tfi(l + 1/(6n)) .

(10)

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.

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

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

But,

Q(O) = +,

0) = -ao~

G(0) = 39(o),

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*:

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.

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.

Trueh Degrees of

variance freedom 0.8 1.0 1.2

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

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.

0.8 1.0 1.2

._

Trueh Degrees of Absolute Percentage Absoluted Percentage Absolut@ Percentage

variance freedom bias bias bias bias bias bias

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

variance freedom estimator estimator estimator estimator estimator estimator

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

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

(A.3)

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

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

Rearranging terms,

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 @.

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

integer), use not s, but 3 divided by

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

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J. S. Butler and B. Schachter, Unhrused estintaimn of the B&k/ Scholes fornulu 351

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Economics 10. 407-432.

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Financial Economics 3. 145-166.

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