Clarifying the dynamics of the relationship between option and stock markets using the threshold vector error correction model

Abstract

This work examines how the option and stock markets are related when using the threshold vector error correction model (hereinafter referred to as threshold VECM). Moreover, compared to previous studies in the literature of application of threshold models, this study not only investigates the impacts of price transmission mechanisms on stock return means but also the volatilities of returns. The model is tested using the U.S. S&P 500 stock market. The empirical findings of this investigation are consistent with the following notions. First, the equilibrium re-establishment process depends primarily on the option market and is triggered only when price deviations exceed a critical threshold. Second, arbitrage behaviors between the option and stock markets increase volatility in these two markets and reduce their correlation.