Tick Size, Microstructure Noise and Volatility Inversion Effects on Price Discovery in Option Markets: Theory and Empirical Evidence

Abstract

We document both theoretically and empirically a major dependence in both the Information Shares (IS) and Component Shares (CS) approaches to the estimation of the price discovery metrics on the errors arising out of the inversion method of the option value to find the implied stock price. We then introduce accurate inversion methods that result in a major increase in the information shares of option markets for both IS and CS metrics compared to the dominant Lagged Implied Volatility (LIV) inversion method. We apply these insights by examining the impact of the tick size reduction introduced by the CBOE in 2007 in its second pilot program on the simultaneous price discovery process in the markets for options and their underlying securities. In all cases we document a major impact of the tick size reduction in the option market that increases the option market information shares for all metrics and all inversion methods.

Keywords: Price discovery, Market microstructure, Option inversion, Stochastic volatility

JEL Classification: G14, G13