Mispricing of S&P 500 Index Options

Widespread violations of stochastic dominance by 1-month S&P 500 index call options over 1986-2006 imply that a trader can improve expected utility by engaging in a zero-net-cost trade net of transaction costs and bid-ask spread. Although precrash option prices conform to the Black-Scholes-Merto...

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Bibliographic Details
Published in:The Review of financial studies 2009-03, Vol.22 (3), p.1247-1277
Main Authors: Constantinides, George M., Jackwerth, Jens Carsten, Perrakis, Stylianos
Format: Article
Language:English
Subjects:
Arbitrage
Asset pricing
Call options
Costs
Economic indices
Economic theory
Expected utility
Financial bonds
Financial engineering
Marginal utility
Market prices
Option pricing
Options markets
Price volatility
Put & call options
Securities prices
Stock exchanges
Stock options
Stock prices
Studies
Transaction costs
Violations
Volatility
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Summary:Widespread violations of stochastic dominance by 1-month S&P 500 index call options over 1986-2006 imply that a trader can improve expected utility by engaging in a zero-net-cost trade net of transaction costs and bid-ask spread. Although precrash option prices conform to the Black-Scholes-Merton model reasonably well, they are incorrectly priced if the distribution of the index return is estimated from time-series data. Substantial violations by postcrash OTM calls contradict the notion that the problem lies primarily with the left-hand tail of the index return distribution and that the smile is too steep. The decrease in violations over the postcrash period of 1988-1995 is followed by a substantial increase over 1997-2006, which may be due to the lower quality of the data but, in any case, does not provide evidence that the options market is becoming more rational over time.
ISSN:0893-9454
1465-7368
DOI:10.1093/rfs/hhn009