Modeling the non‐linear behaviour of option price deviations from the Black Scholes model

Purpose – The purpose of this paper is to test for and model non‐linearities in option price deviations from the Black Scholes (BS) model in FTSE 100 index options over the time period 1997‐2006. Design/methodology/approach – The economic specification and estimation methodology is outlined, the data are discussed, and the empirical results are analysed. Findings – The tests reject the linearity hypothesis and the paper shows that the exponential smooth transition autoregressive model is capable of capturing the non‐linear behaviour of option price misalignments. The paper finds that even though FTSE 100 index options are heavily traded, transaction costs prevent rapid adjustments of option prices from their “optimal” value. Originality/value – The paper presents new empirical evidence, which explicitly allows for the possibility that option price misalignments from the BS price can be characterised by a non‐linear mean reverting process.