Distributions implied by American currency futures options: A ghost's smile?

A new and easily applicable method for estimating risk‐neutral distributions (RND) implied by American futures options is proposed. It amounts to inverting the Barone‐Adesi and Whaley method (BAW method) to get the BAW implied volatility smile. Extensive empirical tests show that the BAW smile is equivalent to the volatility smile implied by corresponding European options. Therefore, the procedure leads to a legitimate RND estimation method. Further, the investigation of the currency options traded on the Chicago Mercantile Exchange and OTC markets in parallel provides us with insights on the structure and interaction of the two markets. Unequally distributed liquidity in the OTC market seems to lead to price distortions and an ensuing interesting “ghost‐like” shape of the RND density implied by CME options. Finally, using the empirical results, we propose a parsimonious generalization of the existing methods for estimating volatility smiles from OTC options. A single free parameter significantly improves the fit. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:147–178, 2004     

The limits to stock index arbitrage: Examining S&P 500 futures and SPDRS

This study examines factors affecting stock index spot versus futures pricing and arbitrage opportunities by using the S&P 500 cash index and the S&P 500 Standard and Poor's Depository Receipt (SPDR) Exchange‐Traded Fund (ETF) as “underlying cash assets.” Potential limits to arbitrage when using the cash index are the staleness of the underlying cash index, trading costs, liquidity (volume) issues of the underlying assets, the existence of sufficient time to execute profitable arbitrage transactions, short sale restrictions, and the extent to which volatility affects mispricing. Alternatively, using the SPDR ETF as the underlying asset mitigates staleness and trading cost problems as well as the effects of volatility associated with the staleness of the cash index. Minute‐by‐minute prices are compared over different volatility levels to determine how these factors affect the limits of S&P 500 futures arbitrage. Employing the SPDR as the cash asset examines whether a liquid tradable single asset with low trading costs can be used for pricing and arbitrage purposes. The analysis examines how long mispricing lasts, the impact of volatility on mispricing, and whether sufficient volume exists to implement arbitrage. The minute‐by‐minute liquidity of the futures market is examined using a new transaction volume futures database. The results show that mispricings exist regardless of the choice of the underlying cash asset, with more negative mispricings for the SPDR relative to the S&P 500 cash index. Furthermore, mispricings are more frequent in high‐ and mid‐volatility months than in low‐volatility months and are associated with higher volume during high‐volatility months. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:1182–1205, 2008     

Intradaily periodicity and volatility spillovers between international stock index futures markets

This paper examines short‐run information transmission between the U.S. and U.K. markets using the S&P 500 and FTSE 100 index futures. Ultrahighfrequency futures data are employed—which have a number of advantages over the low‐frequency spot data commonly used in previous studies—in establishing that volatility spillovers are in fact bidirectional. The generalized autoregressive conditionally heteroskedastic model (GARCH) is employed to estimate the mean and volatility spillovers of intraday returns. A Fourier flexible function is utilized to filter the intradaily periodic patterns that induce serial correlation in return volatility. It was found that estimates of volatility persistence and speed of information transmission are seriously affected by intradaily periodicity. The bias in parameter estimation is removed by filtering out the intradaily periodic component of the transaction data. Contrary to previous findings, there is evidence of spillovers in volatility between the U.S. and U.K. markets. Results indicate that the volatility of the U.S. market is affected by the most recent volatility surprise in the U.K. market. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:553–585, 2005     

A Markowitz Optimization of Commodity Futures Portfolios

We examine the diversification benefits of using individual futures contracts instead of simply a commodity index. We determine the ex‐ante, ex‐post, and stability results for optimal Markowitz portfolios, investigate the instability between the ex‐ante and ex‐post results, and compare our results to traditional and naïve portfolios. The ex‐ante complete futures portfolio dominates the traditional and naive portfolios and the ex‐post portfolio outperforms the naïve portfolio. The instability between the ex‐ante and ex‐post results is primarily driven by the time‐varying returns of the individual assets rather than by risk. Finally, the Sharpe portfolio results are essentially identical to the Markowitz results. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 33:343‐368, 2013     

Implied volatility forecasts in the grains complex

This article finds that the implied volatilities of corn, soybean, and wheat futures options 4 weeks before option expiration have significant predictive power for the underlying futures contract return volatilities through option expiration from January 1988 through September 1999. These implied volatilities also encompass the information in out‐of‐sample seasonal Glosten, Jagannathan, and Runkle (GJR;1993) volatility forecasts. Evidence also demonstrates that when corn‐implied volatility rises relative to out‐of‐sample seasonal GJR volatility forecasts, implied volatility substantially overpredicts realized volatility. However, simulations of trading rules that involve selling corn option straddles when corn‐implied volatility is high relative to out‐of‐sample GJR volatility forecasts indicate that none of the trading rules would have been significantly profitable. This finding suggests that these options are not necessarily overpriced. © 2002 Wiley Periodicals, Inc. Jrl Fut Mark 22:959–981, 2002     

Options on bond futures: Isolating the risk premium

The introduction of unspanned sources of risk (and frictions) implies that option prices include a risk premium. Prima facie evidence of the existence of risk premia in option prices is contained in the implied volatility smile patterns reported in the literature. This article isolates the risk premium (defined as the simple difference between estimated and observed option prices) on options on U.K. Gilts, German Bunds, and U.S. Treasury bond futures using models that include price jumps and stochastic volatility. This study finds that single and multi‐factor stochastic volatility models with jumps may explain the empirical regularities observed in bond futures. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:169–215, 2003     

Stock index futures trading and volatility in international equity markets

This article examines stock market volatility before and after the introduction of equity‐index futures trading in twenty‐five countries, using various models that account for asynchronous data, conditional heteroskedasticity, asymmetric volatility responses, and the joint dynamics of each country's index with the world‐market portfolio. We found that futures trading is related to an increase in conditional volatility in the United States and Japan, but in nearly every other country, we found either no significant effect or a volatility‐dampening effect. This result appears to be robust to model specification and is corroborated by further analysis of the relationship between volatility, trading volume, and open interest in stock futures. An increase in conditional covariance between country‐specific and world returns at the time of futures listing is also documented. © 2000 John Wiley & Sons, Inc. Jrl Fut Mark 20:661–685, 2000     

Multifactor implied volatility functions for HJM models

This study evaluates two one‐factor, two two‐factor, and two three‐factor implied volatility functions in the HJM class, with the use of eurodollar futures options across both strike prices and maturities. The primary contributions of this article are (a) to propose and test three implied volatility multifactor functions not considered by K. I. Amin and A. J. Morton (1994), (b) to evaluate models using the AIC criteria as well as other standard criteria neglected by S. Y. M. Zeto (2002), and (c) to .nd that multifactor models incorporating the exponential decaying implied volatility functions generally outperform other models in .tting and prediction, in sharp contrast to K. I. Amin and A. J. Morton, who find the constantvolatility model superior. Correctly specified and calibrated simple constant and square‐root factor models may be superior to inappropriate multifactor models in option trading and hedging strategies. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:809–833, 2006     

Regime‐switching in stock index and Treasury futures returns and measures of stock market stress

We investigate bivariate regime‐switching in daily futures‐contract returns for the US stock index and ten‐year Treasury notes over the crisis‐rich 1997–2005 period. We allow the return means, volatilities, and correlation to all vary across regimes. We document a striking contrast between regimes, with a high‐stress regime that exhibits a much higher stock volatility, a much lower stock–bond correlation, and a higher mean bond return. The high‐stress regime is associated with higher average values of stock‐implied volatility, stock illiquidity, and stock and bond futures trading volume. The lagged implied volatility from equity‐index options is useful in modeling the time‐varying transition probabilities of the regime‐switching process. Our findings support the notions that: (1) stock market stress can have a material influence on Treasury bond pricing, and (2) the diversification benefits of combined stock–bond holdings tend to be greater during times with relatively high stock market stress. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 30:753–779, 2010     

What moves the tail? The determinants of the option‐implied probability density function of the DAX index

In this article a study of the option‐implied probability density function (PDF) of German stock returns is presented. The use of option prices allows for the quantification of the risk‐neutral probability of large movements in the DAX index. Using daily data for the period from December 1995 to May 2002, the mixture of log‐normals specification with a constant maturity of 49 days is estimated. The time series behavior of the option‐implied PDF during episodes of market turbulence is discussed at the outset. The main purpose of the study is to consider the relationship of summary measures of the option‐implied PDF to macroeconomic news, information from the U.S. stock market, and risk premia. The results suggest the existence of a significant spillover from the U.S. stock market. Returns and the volatility of U.S. stock prices have a strong effect on changes in the lower DAX tail probability, but also on the higher moments of the option‐implied PDF. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:515–536, 2005     

Price discovery in the options markets: An application of put‐call parity

This study investigates the relative rate of price discovery in Taiwan between index futures and index options, proposing a put‐call parity (PCP) approach to recover the spot index embedded in the options premiums. The PCP approach offers the benefits of reducing model risk and alleviating the burden of volatility estimation. Consistent with the trading‐cost hypothesis, a dominant tendency is found for futures and a subordinate but non‐trivial price discovery from options. The relative weight of options price discovery is sensitive to the methodology employed as the means of inferring the option‐implicit spot price. The empirical evidence suggests that the information contained in the PCP‐implied spot encompasses that provided by the Black‐Scholes‐implied spot. © 2008 Wiley Periodicals, Inc. Jrl Fut Mark 28:354– 375, 2008     

Does Index Futures Trading Reduce Volatility in the Chinese Stock Market? A Panel Data Evaluation Approach

This study investigates the effect of introducing index futures trading on the spot price volatility in the Chinese stock market. We employ a recently developed panel data policy evaluation approach (Hsiao, Ching, and Wan, 2011) to construct counterfactuals of the spot market volatility, based mainly on cross‐sectional correlations between the Chinese and international stock markets. This new method does not need to specify a particular regression or a time‐series model for the volatility process around the introduction date of index futures trading, and thus avoids the potential omitted variable bias caused by uncontrolled market factors in the existing literature. Our results provide empirical evidence that the introduction of index futures trading significantly reduces the volatility of the Chinese stock market, which is robust to different model selection criteria and various prediction approaches. © 2012 Wiley Periodicals, Inc. Jrl Fut Mark 33:1167–1190, 2013     

New evidence on expiration‐day effects using realized volatility: An intraday analysis for the Spanish stock exchange

Additional evidence is provided on expiration effects in the Ibex 35 stock index futures market using realized volatility as proposed by T. G. Andersen, T. Bollerslev, F. X. Diebold, and P. Labys (2003). Findings reveal not only a significant increase in spot trading activity, but also the existence of a significant jump in spot volatility at index futures expiration. Moreover, the importance of the data frequency considered is analyzed. Our research reveals that the use of GARCH methodology from daily data does not have the ability to statistically assess such expiration‐day effect. Additional empirical evidence is provided for the S&P 500 stock index futures market. Neither unconditional nor conditional realized volatility has a significant increase at expiration for the U.S. market, suggesting that this effect is specific for the Spanish market, at least for the period analyzed. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:923–938, 2006     

Economic uncertainty,trading activity,and commodity futures volatility

This paper investigates the dynamics of commodity futures volatility. I derive the variance decomposition for the futures basis and show unexpected excess returns result from new information about expected future interest rates, convenience yields, and risk premia. Measures of uncertainty in economic conditions have significant predictive power for realized volatility of commodity futures returns, after controlling for lagged volatility, returns, commodity index trading, hedging pressure, and other trading activity, even during the so-called “index financialization” period. During this period, hedge fund performance predicts volatility in grain commodities, which are affected by the US ethanol mandate.     

The performance of traders' rules in options market

This study focuses on the usefulness of the traders' rules to predict future implied volatilities for pricing and hedging KOSPI 200 index options. There are two versions of this approach. In the “relative smile” approach, the implied volatility skew is treated as a fixed function of moneyness. In the “absolute smile” approach, the implied volatility skew is treated as a fixed function of the strike price. It is found that the “absolute smile” approach shows better performance than Black, F. and Scholes, L. ( 1973 ) model and the stochastic volatility model for both pricing and hedging options. Consistent with Jackwerth, J. C. and Rubinstein, M. (2001) and Li, M. and Pearson, N. D. (2007), the traders' rules dominate mathematically more sophisticated model, that is, the stochastic volatility model. The traders' rules can be an alternative to the sophisticated and complicated models for pricing and hedging options. © 2009 Wiley Periodicals, Inc. Jrl Fut Mark 29:999–1020, 2009     

Stock index futures markets: stochastic volatility models and smiles

This study examined whether the inclusion of an appropriate stochastic volatility that captures key distributional and volatility facets of stock index futures is sufficient to explain implied volatility smiles for options on these markets. I considered two variants of stochastic volatility models related to Heston (1993). These models are differentiated by alternative normal or nonnormal processes driving log‐price increments. For four stock index futures markets examined, models including a negatively correlated stochastic volatility process with nonnormal price innovations performed best within the total sample period and for subperiods. Using these optimal stochastic volatility models, I determined the prices of European options. When comparing simulated and actual options prices for these markets, I found substantial differences. This suggests that the inclusion of a stochastic volatility process consistent with the objective process alone is insufficient to explain the existence of smiles. © 2001 John Wiley & Sons, Inc. Jrl Fut Mark 21:43–78, 2001     

The information content of option implied volatility surrounding the 1997 Hong Kong stock market crash

This study examines the information conveyed by options and examines their implied volatility at the time of the 1997 Hong Kong stock market crash. The author determines the efficiency of implied volatility as a predictor of future volatility by comparing it to other leading indicator candidates. These include volume and open interest of index options and futures, as well as the arbitrage basis of index futures. Using monthly, nonoverlapping data, the study reveals that implied volatility is superior to those variables in forecasting future realized volatility. The study also demonstrates that a simple signal extraction model could have produced useful warning signals prior to periods of extreme volatility. These results indicate that the options market is highly efficient informationally. © 2007 Wiley Periodicals, Inc. Jrl Fut Mark 27:555–574, 2007     

A No‐Arbitrage Fractional Cointegration Model for Futures and Spot Daily Ranges

The no‐arbitrage relation between futures and spot prices implies an analogous relation between futures and spot daily ranges. The long‐memory features of the range‐based volatility estimators are analyzed, and fractional cointegration is tested in a semi‐parametric framework. In particular, the no‐arbitrage condition is used to derive a long‐run relationship between volatility measures and to justify the use of a fractional vector error correction model (FVECM) to study their dynamic relationship. The out‐of‐sample forecasting superiority of FVECM, with respect to alternative models, is documented. The results highlight the importance of incorporating the long‐run equilibrium in volatilities to obtain better forecasts, given the information content in the volatility of futures prices. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark 33:77–102, 2013     

Information and Noise in U.K. Futures Markets

This paper examines the extent to which futures price changes are driven by noise and information for three U.K. futures contracts by utilizing T. Andersen's (1996) specification of the mixture of distributions hypothesis. Use of the generalized method of moments approach demonstrates that the link between futures volume and volatility can be attributed to the flow of information. More importantly, it is shown that price movements are dominated by informed rather than noise trading for the FTSE‐100, the Long Gilt, and the Brent Oil futures contracts. The results suggest that further regulation based on the notion that noise traders dominate futures trading is unwarranted. © 2004 Wiley Periodicals, Inc. Jrl Fut Mark 24:711–731, 2004     

Hedging long‐term commodity risk

This study focuses on the problem of hedging longer‐term commodity positions, which often arises when the maturity of actively traded futures contracts on this commodity is limited to a few months. In this case, using a rollover strategy results in a high residual risk, which is related to the uncertain futures basis. We use a one‐factor term structure model of futures convenience yields in order to construct a hedging strategy that minimizes both spot‐price risk and rollover risk by using futures of two different maturities. The model is tested using three commodity futures: crude oil, orange juice, and lumber. In the out‐of‐sample test, the residual variance of the 24‐month combined spot‐futures positions is reduced by, respectively, 77%, 47%, and 84% compared to the variance of a naïve hedging portfolio. Even after accounting for the higher trading volume necessary to maintain a two‐contract hedge portfolio, this risk reduction outweighs the extra trading costs for the investor with an average risk aversion. © 2003 Wiley Periodicals, Inc. Jrl Fut Mark 23:109–133, 2003