Department of Economics

The Impact of Serial Correlation on Option Prices in a Non-Frictionless Environment:

Department of Economics

University of Delaware

Working Paper #2005-12

The Impact of Serial Correlation on Option Prices in a Non-Frictionless Environment:
An Alternative Explanation for Volatility Skew

John S. Ying

Joel S. Sternberg


A persistent anomaly in option pricing is the volatility skew.  Many have attempted to explain it with stochastic volatility and/or jump diffusion models with mixed results.  We propose a model that incorporates positive serial correlation in the stock price process and test it on empirical data for four “momentum” stocks and their heavily traded options. Although the notion of serial correlation seems to challenge the notion of arbitrage enforced option valuation, in fact, the existence of transaction costs, discontinuities and other frictions in the market allow for fairly wide arbitrage-free bounds on option prices.  Within these bounds, serial correlation seems to explain not only the often-noted skew in stock option prices, but also the rarely noted upward bias of implied volatilities over actual volatilities.


JEL Codes: G13—Contingent Pricing; G12—Asset Pricing
Keywords: Options, Implied Volatility, Volatility Skew

The Lerner College is home to a state-of-the-art financial trading facility, the $1.4 million student-led Blue Hen Investment Fund, a student-managed restaurant and hotel, a high-technology development center of a global bank and a start-up experience for students with new business ideas.

Lerner College faculty - like Anu Sivaraman, who is among Social Media Marketing Magazine’s “Top 100 Marketing Professors on Twitter” and’s “Top 50 Marketing Professors on Twitter” - are thought leaders who command attention from influential business audiences, economists and policy makers.

All Lerner College departments offer experience-driven learning and emphasize evidence-based analytics methods to enrich the student experience. Here, finance students visit New York City’s financial districts for a first-hand look at markets trading and to meet with UD alumni.

Charles W. Horn, AS75, and wife Patricia, recently made a $3 million commitment to enhance and expand entrepreneurial studies.

  • Alfred Lerner College of Business & Economics
    303 Alfred Lerner Hall  •  Newark, DE 19716  •  USA  •  ©