Stock market efficiency and price predictions implicit in option trading

Abstract

The Black-Scholes option pricing model (with approximate adjustments for dividends and exercise price changes) was used to generate stock prices which are “implied” by the model. If the stock market is efficient, these implied prices should not be capable of being used profitably by traders. This hypothesis is tested using prices established in the Australian Options Market and the Sydney Stock Exchange over the period February 1976 to December 1980. A close correspondence is found between implied stock prices and actual stock prices. Tests of the predictive power of the implied prices were unable to discover evidence of market inefficiency. However, a simulated trading strategy executed ove..