A Framework for Studying Option Mispricing: A General Test and Empirical Evidence

Abstract

Extant empirical evidence on stock option returns suggests that certain classes of options may be mispriced. This paper develops a general test to examine option mispricing and exploits the methodology to investigate mispricing in options on stock indexes and options on 100 large US stocks. We evaluate the relative degree of mispricing in the option market compared to the stock and bond markets, and find no evidence of mispricing in options with maturity above one month, and at-the-money or out-of-the-money options. While we do find support for the mispricing of one-month deep-out-of-the-money options, the relative value of these mispriced options is about 1%. Accordingly, our empirical evidence demonstrates that option mispricing has only negligible economic significance and is limited to a tiny segment of the stock options market, and does not warrant strong conclusions about the mispricing of the options universe.