Black Scholes Option Pricing with Stochastic Returns on Hedge Portfolio

The Black Scholes model of option pricing constitutes the cornerstone of contemporary valuation theory. However, the model presupposes the existence of several unrealistic and rigid assumptions including, in particular, the constancy of the return on the “hedge portfolio”. There, now, subsists ample justification to the effect that this is not the case. Consequently, several generalisations of the basic model have been attempted. In this paper, we attempt one such generalisation based on the assumption that the return process on the “hedge portfolio” follows a stochastic process similar to the Vasicek model of short-term interest rates. c © Electronic Journal of Theoretical Physics. All rights reserved.