Noise traders, mispricing, and price adjustments in derivatives markets

Abstract

ABSTRACTThis study examines disagreements between actual and options-implied futures prices and the corresponding adjustments in a sophisticated setting. We identify the market that triggers each type of price disagreement and find that the market in which the disagreement is initiated adjusts more to eliminate the mispricing. Futures prices adjust less for options-initiated price disagreements with out-of-the-money (OTM) options-implied prices than they do for disagreements with at-the-money (ATM) prices. Options markets adjust more when disagreements are initiated by OTM options than they do when disagreements are initiated by ATM options. Adjustments in both the futures and options markets consistently suggest that OTM options trading provides inferior information. Price disagreements are positively correlated with the participation of domestic investors, especially when they trade OTM options, implying that domestic investors are noisier and less informed than foreign investors are.HighlightsWe examine disagreements between actual and options-implied futures prices and the corresponding adjustments.The market in which the disagreement is initiated adjusts more to eliminate the mispricing.Out-of-the-money options-initiated price disagreements are positively correlated with domestic investors’ trades.