Bid-ask spreads and volatility estimates: The implications for option pricing

This paper re-examines the variance related mispricing exhibited by the Black-Scholes model by accounting for the effects of bid-ask spreads on the estimation of the variance of returns on a security. It is shown that volatility estimates based on observed sequences of transaction prices overestimate the ‘true’ volatility of returns on a security, with the magnitude of the overestimation being an increasing function of the level of the volatility. The paper then provides empirical tests of the proposition that the variance related bias exhibited by the Black-Scholes model is due to this misestimation of volatility. The results indicate that although the misestimation is systematically related to the variance, it is not of sufficient magnitude to explain the volatility bias exhibited by Black-Scholes model.