Option pricing on stocks in mergers and acquisitions

We develop an arbitrage-free and complete framework to price options on the stocks of firms involved in a merger or acquisition deal allowing for the possibility that the deal might be called off at an intermediate time, creating discontinuous impacts on the stock prices. Our model can be a normative tool for market makers to quote prices for options on stocks involved in such deals and also for traders to control risks associated with such deals using traded options. The results of tests indicate that the model performs significantly better than the Black-Scholes model in explaining observed option prices.