Mispricing in Indian Derivatives Markets: An Analytical Study of Options Contracts

Abstract

One reason for the phenomenal success of options is the fact that they can be priced. Pricing usually means that there is an active and a liquid market with many buyers and sellers that generate a continuous flow of prices for a specific instrument. However, the pricing of options goes beyond supply and demand fundamentals. It is well known that severe mispricing prevails in India’s nascent derivatives market. Understanding the concept of volatility is essential to option trading success. A trader who can recognize whether a given option or series of options is cheap or expensive on a historic basis has a tremendous advantage in the marketplace. Flexible traders can buy premium when volatilities are low and sell premium when volatilities are high. They can establish spreads in which they buy inexpensive options and sell expensive options, thus obtaining the best of both worlds. Over the past few decades, there has been a vast quantity of research dedicated to modeling the joint dynamics of stock returns and volatility. It is now widely recognized that volatility varies substantially over time, and that volatility changes are persistent and somewhat predictable (Bollerslev Etal., 1992; Harvey & Whaley, 1992; Schwert, 1989). It is also widely accepted that option prices incorporate forward-looking information that helps forecast future volatility (Christensen & Prabhala, 1998; Day & Lewis, 1992; l-leming, 1998; Lamoureux & Lastrapes, 1993). This paper empirically examines the implied volatility function for selected individual equity call options from Indian Stock Market for the period 1st April 2007 to 31st March 2009 and tries to find out the extend of mispricing, the implied volatility and the U-shaped smile pattern.