CFDP 1964

A Multivariate Stochastic Unit Root Model with an Application to Derivative Pricing

Author(s): 

Publication Date: December 2014

Pages: 56

Abstract: 

This paper extends recent findings of Lieberman and Phillips (2014) on stochastic unit root (SUR) models to a multivariate case including a comprehensive asymptotic theory for estimation of the model’s parameters. The extensions are useful because they lead to a generalization of the Black-Scholes formula for derivative pricing. In place of the standard assumption that the price process follows a geometric Brownian motion, we derive a new form of the Black-Scholes equation that allows for a multivariate time varying coefficient element in the price equation. The corresponding formula for the value of a European-type call option is obtained and shown to extend the existing option price formula in a manner that embodies the effect of a stochastic departure from a unit root. An empirical application reveals that the new model is consistent with excess skewness and kurtosis in the price distribution relative to a lognormal distribution.

Keywords: 

Autoregression; Derivative, Diffusion, Options, Similarity, Stochastic unit root, Time-varying coefficients

JEL Classification Codes: C22