One option-pricing problem that has hitherto been unsolved is the pricing of a European call on an asset that has a stochastic volatility. This paper examines this problem. The option price is determined in series form for the case in which the stochastic volatility is independent of the stock price. Numerical solutions are also produced for the case in which the volatility is correlated with the stock price. It is found that the Black-Scholes price frequently overprices options and that the degree of overpricing increases with the time to maturity. This paper produces a solution in series form for the situation in which the stock price is instantaneously uncorrelated with the volatility. We do not assume that the volatility is a traded asset. Also, a constant correlation between the instantaneous rate of change of the volatility and the rate of change of aggregate consumption can be accommodated. The option price is lower than the BlackScholes (B-S) [1] price when the option is close to being at the money and higher when it is deep in or deep out of the money. The exercise prices for which overpricing by B-S takes place are within about ten percent of the security price. This is the range of exercise prices over which most option trading takes place, so we may, in general, expect the B-S price to overprice options. This effect is exaggerated as the time to maturity increases. One of the most surprising implications of this is that, if the B-S equation is used to determine the implied volatility of a near-the-money option, the longer the time to maturity the lower the implied volatility. Numerical solutions for the case in which the volatility is correlated with the stock price are also examined. ONE OPTION-PRICINGThe stochastic volatility problem has been examined by Merton

This article shows that the one-state-variable interest-rate models of Vasicek (1977) and Cox, Ingersoll, and Ross (1985b) can be extended so that they are consistent with both the current term structure of interest rates and either the current volatilities of all spot interest rates or the current volatilities of all forward interest rates. The extended Vasicek model is shown to be very tractable analytically. The article compares option prices obtained using the extended Vasicek model with those obtained using a number of other models.

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A self-scanned 1024 element photodiode array and minicomputer are used to measure the phase (wavefront) in the interference pattern of an interferometer to lambda/100. The photodiode array samples intensities over a 32 x 32 matrix in the interference pattern as the length of the reference arm is varied piezoelectrically. Using these data the minicomputer synchronously detects the phase at each of the 1024 points by a Fourier series method and displays the wavefront in contour and perspective plot on a storage oscilloscope in less than 1 min (Bruning et al. Paper WE16, OSA Annual Meeting, Oct. 1972). The array of intensities is sampled and averaged many times in a random fashion so that the effects of air turbulence, vibrations, and thermal drifts are minimized. Very significant is the fact that wavefront errors in the interferometer are easily determined and may be automatically subtracted from current or subsequent wavefrots. Various programs supporting the measurement system include software for determining the aperture boundary, sum and difference of wavefronts, removal or insertion of tilt and focus errors, and routines for spatial manipulation of wavefronts. FFT programs transform wavefront data into point spread function and modulus and phase of the optical transfer function of lenses. Display programs plot these functions in contour and perspective. The system has been designed to optimize the collection of data to give higher than usual accuracy in measuring the individual elements and final performance of assembled diffraction limited optical systems, and furthermore, the short loop time of a few minutes makes the system an attractive alternative to constraints imposed by test glasses in the optical shop.

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