Which Traders Contribute Most to Price Discovery? Evidence from the KOSPI 200 Options Market

We examine which group of investors—individuals, institutions, or foreigners—has more information about the true price process in the Korea Stock Price Index 200 (KOSPI 200) options market. Using the Hasbrouck (1995) information share and the Gonzalo and Granger (1995) common factor weight approach, we show that foreigners are the most informative about the efficient price process, and domestic institutional investors as well as individual investors have small contribution to price discovery. This result holds firmly, even after controlling for the effects of trading volume and the number of trades. Our empirical results suggest that foreigners are informed traders in the KOSPI 200 options market, consistent with the findings of Ahn, Kang, and Ryu (2008).     

Pricing Efficiency in a Thin Market with Competitive Market Makers: Box Spread Strategies in the Hang Seng Index Options Market

Using a box spread arbitrage strategy, we examine the pricing efficiency of the emerging, thinly traded Hang Seng Index options market in Hong Kong, where market makers operate under a competitive open outcry system. In 20 months of tick‐by‐tick bid‐ask and transaction quotes we find very few arbitrage opportunities. Our examination of the reporting time of quotes shows that in effect, all the apparent mispricings are deceptive and could be explained by stale quotes. The absence of real arbitrage opportunities supports the pricing rationality hypothesis in the Hong Kong options market.     

Pricing Commodity Spread Options with Stochastic Term Structure of Convenience Yields and Interest Rates

The purpose of this research is to provide a valuation formula for commodity spread options. Commodity spread options are options written on the difference of the prices (spread) of two commodities. From the aspect of commodity contingent claims, it is considered that commodity spread options are difficult to evaluate with accuracy because of the existence of the convenience yield. Hence, the model of the convenience yield is the key factor to price commodity spread options. We use the concept of future convenience yields to develop the model that enriches the stochastic behavior of convenience yield. We also introduce Heath-Jarrow-Morton interest rate model to the valuation framework. This general model not only captures the mean reverting feature of the convenience yield, but also allows us to handle a very wide range of shape that the term structure of convenience yield can take. Therefore our model provides various types of models. The numerical analysis presented in this paper provides some unique features of commodity spread options in contrast to normal options. These characteristics have never been addressed in previous studies. Moreover, it suggests that the existing model overprice commodity spread options through neglecting the effect of interest rates.     

EMPIRICAL TESTS OF THE EFFICIENCY OF THE CURRENCY OPTION MARKET

Tests of a hedge and a rational boundary of the efficiency of the currency option market are conducted in this study. These tests use transactions data and account for the effects of currency and option bid/ask spreads, synchronization of option prices and underlying exchange rates, market depth, execution lags, and transaction costs. Currency options, unlike domestic stock options, exhibit continuous dividends. The nature of the option and of the data set employed makes the immediate exercise lower bound test one of the purest tests of market efficiency to date. Results reported here indicate no ability to earn abnormal economic or riskless arbitrage profit for the period when these tests are conducted.     

Brealey,Myers, and Allen on Real Options

Real options are valuable sources of flexibility that are either inherent in, or can be built into, corporate assets. The value of such options are generally not captured by the standard discounted cash flow (DCF) approach, but can be estimated using a variant of financial option pricing techniques. This article provides an overview of the basics of real option valuation by examining four important kinds of real options:

• 1 The option to make follow‐on investments. Companies often cite “strategic” value when taking on negative‐NPV projects. A close look at the payoffs from such projects reveals call options on follow‐on projects in addition to the immediate cash flows from the projects. Today's investments can generate tomorrow's opportunities.
• 2 The option to wait (and learn) before investing. This is equivalent to owning a call option on the investment project. The call is exercised when the firm commits to the project. But often it's better to defer a positive‐NPV project in order to keep the call alive. Deferral is most attractive when uncertainty is great and immediate project cash flows—which are lost or postponed by waiting—are small.
• 3 The option to abandon. The option to abandon a project provides partial insurance against failure. This is a put option; the put's exercise price is the value of the project's assets if sold or shifted to a more valuable use.
• 4 The option to vary the firm's output or its production methods. Companies often build flexibility into their production facilities so that they can use the cheapest raw materials or produce the most valuable set of outputs. In this case they effectively acquire the option to exchange one asset for another.

The authors also make the point that, in most applications, real‐option valuation methods are a complement to, not a substitute for, the DCF method. Indeed DCF, which is best suited to and usually sufficient for safe investments and “cash cow” assets, is typically the starting point for real‐option analyses. In such cases, DCF is used to generate the values of the “underlying assets”—that is, the projects when viewed without their options or sources of flexibility.     

INSTITUTIONAL TRADING AND SECURITY PRICES: THE CASE OF CHANGES IN THE COMPOSITION OF THE S&P 500 INDEX

This paper examines the common stock valuation and liquidity effects of firms being added to and deleted from the S&P 500 Index. Three potential pricing and trading volume hypotheses are discussed and tested—an Information Content Hypothesis (ICH), a Price Pressure Hypothesis (PPH), and a Liquidity Cost Hypothesis (LCH). The empirical findings indicate that firms being added to (deleted from) the S&P 500 Index over the 1977 to 1983 period experience positive (negative) abnormal common stock returns on the day following the addition. An analysis of common stock liquidity around additions to the Index reveals that while relative trading activity increases in the month of addition, it actually declines in subsequent months. The valuation and liquidity results are consistent to some degree with both the PPH and the LCH and are most likely due to index fund managers adjusting their holdings to reflect changes in the Index.     

Informed trading under different market conditions and moneyness: Evidence from TXO options

We examine the informational role of options across exercise prices under different market conditions. We analyze the influence of options' leverage effect, and market cycles on the cause–effect relation between stock and options markets based on an emerging options market—the Taiwan stock index options market. When aggregating market data irrespective of market cycles and options moneyness, we find that the equity market leads the options market. However, as we control options' moneyness and market cycles, we find that out-of-the-money options lead the stock market by up to 90 min with more pronounced results in downtrends and periods of political tension. Our findings suggest that the informational role of options is interacted with leverage effect and market conditions.     

Index Options: The Early Evidence

Index options became the most important traded contracts during their first year of existence. Two contracts, namely those on the S&P100 and the Major Markets Index, have a trading volume which typically surpasses the trading volume in all individual stock option contracts. In this paper, we examine the pricing of the options on the S&P100 and the Major Markets Index. Using intra-day prices, we find the options frequently violate the arbitrage boundary, put/call parity, and are substantially mispriced relative to theoretical values. Our results suggest that tests of option pricing models may be more difficult than previously realized due to nonsynchronous prices, even using “real-time” data from the exchanges.     

Trading activity and bid–ask spreads of individual equity options

We empirically examine the impact of trading activities on the liquidity of individual equity options measured by the proportional bid–ask spread. There are three main findings. First, the option return volatility, defined as the option price elasticity times the stock return volatility, has a much higher power in explaining the spread variations than the commonly considered liquidity determinants such as the stock return volatility and option trading volume. Second, after controlling for all the liquidity determinants, we find a maturity-substitution effect due to expiration cycles. When medium-term options (60–90 days maturity) are not available, traders use short-term options as substitutes whose higher volume leads to a smaller bid–ask spread or better liquidity. Third, we also find a moneyness-substitution effect induced by the stock return volatility. When the stock return volatility goes up, trading shifts from in-the-money options to out-of-the-money options, causing the latter’s spread to narrow.     

Pricing U.S. Dollar Index Futures Options: An Empirical Investigation

This paper develops a pricing model and empirically tests the pricing efficiency of options on the U.S. Dollar Index (USDX) futures contract. Empirical tests of the model indicate that the market consistently overprices these options relative to the derived model. This overpricing is more pronounced for out‐of‐the‐money options than for in‐the‐money options and more pronounced for put options than for call options. To validate the above results, delta neutral portfolios are created for one‐ and two‐day holding periods and consistently generate positive arbitrage profits, indicating that on average the market overprices the options on the USDX futures contracts.     

The liquidity effects associated with addition of a stock to the S&P 500 index: evidence from bid/ask spreads

This study examines changes in stock liquidity, as measured by the bid/ask spread, when a stock is added to the S&P 500 Index. The paper presents evidence of a significant decrease in the bid/ask spread upon S&P 500 addition, however, this effect is limited to only those stocks that were not trading listed options. Further, the decrease in the bid/ask spread for nonoptioned stocks is accompanied by a significant and permanent increase in share price and trading volume. While optioned stocks experience a permanent increase in trading volume, they experience only a temporary increase in share price. The findings for optioned stocks support the hypothesis that the price and volume effects associated with S&P 500 addition derive from temporary price pressure. Findings pertaining to the nonoptioned stocks indicate that the price and volume effects associated with S&P addition reflect enhanced stock liquidity. The decrease in the bid/ask spread for nonoptioned stocks is attributed to informational efficiencies achieved via index arbitrage trading, and it is argued that this effect is mitigated for optioned stocks due to the pre-existence of arbitrage trading between the option and the underlying stock.     

THE EFFECT OF THE SEC'S ORDER-HANDLING RULES ON NASDAQ

We study the effect of the implementation of new Securities and Exchange Commission order-handling rules—the Limit Order Display Rule, the Quote Rule, and the Actual Size Rule—on NASDAQ's quoting and trading behavior. We find that the number of reported quotes increases and the bid-ask spread decreases following the implementation of the new rules. The decreased quoted depth associated with placement of individual investors' limit orders—the Limit Order Display Rule—outweighs the increased quoted depth associated with displaying institutional quotes—the Quote Rule. Further, the number of trade executions increases while the average trade size decreases. The volatility of trade-to-trade and midpoint returns decreases for the initial group of stocks subject to the rules, but not for the two subsequent groups.     

THE VALUATION OF CURRENCY OPTIONS FOR ALTERNATE STOCHASTIC PROCESSES

This paper compares the ability of four valuation models — the Pure Diffusion model of Black-Scholes-Merton, the Absolute Diffusion and Pure Jump models of Cox-Ross, and the mixed Jump-Diffusion model of Merton — to explain the observed behavior of market prices of foreign currency options. The empirical tests are based on a comparison of the pattern of implied volatilities obtained from option market prices and the Black-Scholes-Merton model with those expected theoretically if exchange rates follow the four stochastic processes specified above. The results of the comparison show that the pattern of implied volatilities is most consistent with the mixed Jump-Diffusion model.     

Effects of the volatility smile on exchange settlement practices: The Hong Kong case

The well-documented volatility smile phenomenon in the US options market has affected the option settlement practices of other markets. To settle Hang Seng Index (HSI) options, the Hong Kong Stock Exchange artificially builds in a piecewise linear “smile” or “sneer” volatility function, which is determined daily by market makers rather than directly by market forces. In this study, we investigate the time-varying settlement function and find the following economic determinants of the volatility function: lag parameters, current-day HSI returns, the distribution of HSI returns, transaction costs as proxied by the bid-ask spread, and the “Monday effect”. For evaluation purposes, we use as a benchmark the estimated piecewise linear volatility function as directly driven by market forces. The comparison analyses show that base volatilities set by market makers run somewhat high, while downside slopes are not steep enough. This results in the overpricing of the lion’s share of traded options. An economic determinants analysis of market-force-driven parameters reveals that market makers can better align artificial volatility parameters both by reducing reliance on the function parameters of prior days and by more precisely accounting for current-day HSI returns, option time-to-maturity, bid-ask spreads and buying pressure.     

Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests

The relation between the square of the quoted bid-ask spread and two serial covariances—the serial covariance of transaction returns and the serial covariance of quoted returns—is modeled as a function of the probability of a price reversal, π, and the magnitude of a price change, ?, where ? is stated as a fraction of the quoted spread. Different models of the spread are contrasted in terms of the parameters, π and ?. Using data on the transaction prices and price quotations for NASDAQ/NMS stocks, π and ? are estimated and the relative importance of the components of the quoted spread—adverse information costs, order processing costs, and inventory holding costs—is determined.     

RAISING CONTINGENT CAPITAL: THE CASE OF CEPHALON

In early 1997, Cephalon, Inc., a biotechnology firm, purchased 2.5 million capped call options on its own stock, with a potential value of as much as $45 million, in exchange for $9.8 million worth of its common shares. Cephalon's first major drug, Myotrophin, was under review by the U.S. Food and Drug Administration, and Cephalon's management reasoned that, upon FDA approval, the company's stock would rise in value to reflect the future value of the drug, in which case the call options would pay off and the firm could use the proceeds to help fund commercialization of the drug. The managers thus viewed the call options as a form of “contingent capital,” capital that would be available only if and when the firm needed it. The availability and cost of financing constitute major uncertainties for any company and perhaps even more so for a biotech firm. But was the options transaction a cost‐effective way to raise capital? The authors' analysis suggests that the cost of the capped calls—underwriting fees, expenses, underpricing, and market impact—was quite high compared to alternative sources of financing that may have been available to Cephalon in the wake of a favorable decision by the FDA. An equally interesting aspect of this case is that the size of Cephalon's funding requirements was determined in large part by accounting rules and management's desire to report higher (non‐cash) earnings.     

Trading volatility spreads: a test of index option market efficiency

If returns on two assets share common volatility components, the prices of options on the assets should be interdependent and the implied volatility spread should mean revert. We first demonstrate, using the canonical correlation method, that there is a common component in the volatilities of the returns on S&P 100 and S&P 500 indices. We then exploit this commonality by trading on the volatility spread between tick-by-tick OEX and SPX call options listed on the CBOE. Our vega-delta-neutral strategies generated significant profits, even after transaction costs are taken into account. The results suggest that the two options markets are not jointly efficient.     

THE PROPOSED INTRODUCTION OF FUTURES‐STYLE MARGINING IN THE UNITED STATES: AN AUSTRALIAN COMPARISON

We extend the quadratic approximation method to examine American‐style options traded using futures‐style margining and show that an early exercise premium can exist when the cost of carry is negative. Empirical results based on a reduced form of the model using futures‐style call options traded on the Australian All Ordinaries Share Price Index are consistent with previous research: call option early exercise premiums are economically zero. Full option prices are examined by comparing observed futures‐style with theoretical stock‐style values. We find futures‐style values exceed stock‐style values and argue that the increase results from improvements in liquidity. The findings are particularly relevant given the pending decision at the Commodity Futures Trading Commission to introduce a futures‐style system in the United States. JEL classification: G13, C13     

Implied Volatility in Options Markets and Conditional Heteroscedasticity in Stock Markets

This study examines whether or not the volatility of stock index returns forecasted by a GARCH-M specification is consistent with the implied volatility observed in options markets. Recent data for the New York Stock Exchange Composite Index and Standard & Poor's 500 Index and their options are employed. The patterns of the term structure of implied volatility are compared with those of volatility estimates obtained from the GARCH process. The results indicate that the GARCH process appears to partially explain the variation of implied volatilities and the term structure of implied volatilities.     

Valuing debt options: Empirical evidence

A two-factor model using the instantaneous rate of interest and the return on a consol bond to describe the term structure of interest rates — the Brennan-Schwartz model — is used to derive theoretical prices for American call and put options on US government bonds and treasury bills. These model prices are then compared with market prices. The theoretical model used to value the dept options also provides hedge ratios which may be used to construct zero-investment portfolios which, in theory, are perfectly riskless. Several trading strategies based on these ‘riskless’ portfolios are examined.