Do Lead-Lag Effects Affect Derivative Pricing?

Abstract

In this paper we extend an analysis by Lo and Wang (1995), who showed that predictability of asset returns affects derivatives prices through its impact on instantaneous volatility. We investigate how the whole instantaneous variance-covariance matrix of two assets returns is affected by typical lead-lag patterns. A close link between the cross-autocorrelations of finite holding-period returns and the instantaneous correlation is derived, which implies a strong impact of lead-lag patterns on correlation dependent derivatives. We provide simple adjustments for lead-lag effects and apply our results to the valuation of stock option plans.