Initial Offerings of Options

Abstract

This paper considers the introduction of stock options in an (dynamically) incomplete securities market made up of a riskless bond and the stock. The stock price follows a geometric Brownian motion with constant drift. However, there is incomplete information about the unknown stochastic volatility. The option price is determined by a uniform-price auction. Thus an option pricing formula results from the interaction of market participants relying on private information on the unknown stochastic volatility under an explicit market structure. This paper incorporates market microstructure considerations into an extended Black-Scholes model with incomplete information on the underlying volatility. It relies on the growing importance of auctionlike trading rules in financial markets.