Testing Lower Boundary Conditions for Index Options Using Futures Prices: Evidences from the Indian Options Market

Abstract

Options are the contracts which serve as a tool for risk hedging, price discovery, and better allocation of capital. The efficiency of an options market, i.e., the correctness of option prices denotes that it is working well at its well-identified functions (Ackert and Tian, 2000). In view of this, the efficiency of options market has been of equal interest to the academics as well as practitioners and a number of studies on efficiency of options market have been carried out across the globe in different options markets. The present paper attempts to assess the pricing efficiency of the S&P CNX Nifty index options in India by testing the Lower Boundary Conditions (LBCs) using futures prices instead of spot values. The methodology adopted essentially tests a joint market efficiency hypothesis of index options and index futures. This has been done in view of the fact that the use of futures markets helps in doing away with the short-selling constraint as futures can easily be shorted. And, it becomes a natural choice for analysis as the short-selling has been banned in the Indian securities market during the period under reference. Moreover, the use of futures markets, to a marked extent, helps in ensuring the exploitability of arbitrage opportunities when underlying asset is an index. The study covers a period of six years from June 4, 2001 (starting date for index options in India) to June 30, 2007. The major findings of the study are: The put options market is more efficient than the call options market, given the existing market microstructure in India during the period under reference. Another equally important finding is that the put options market showed an improvement in the pricing efficiency over the years whereas the call options market demonstrated a counterintuitive and adverse development. However, the profit potential offered by highly traded opportunities both in the cases of call and put options seems to be unexploitable in the presence of transaction costs. Moreover, the dearth of liquidity in the case of otherwise exploitable opportunities which carry higher profit potentials has been the main inhibiting factor to arbitrageurs. Therefore, in short, it is reasonable to conclude that majority of violations in call as well as put options could not be exploited on account of the existing market-microstructure in India during the period under reference (especially short-selling constraint that caused underpricing in futures to persist) and the dearth of liquidity in the options market. In other words, the revealed state of options pricing can be designated to the short-selling constraints and dearth of liquidity.