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

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.