Price Discovery Across Equity and Option Markets

57 Pages Posted: 15 Sep 2013 Last revised: 12 Sep 2014

Hayden Kane

Federal Reserve Banks - Federal Reserve Bank of Richmond

Date Written: September 4, 2014

Abstract

This paper measures the channels by which private information is incorporated in prices in the equity and option markets. Using a mispricing events approach and conditioning on the option market being the cause of the mispricing event, I analyse the subsequent behaviour of both the options and equity markets and I find that options markets play an important role in the price discovery process. When conditioning on option caused mispricing events, the equity price adjusts towards the options price to reconcile the prices. I find that around 40% of the option caused mispricing events contain information, and the equity prices adjust 35-40%, depending on the exchange, of the maximum discrepancy before prices reconcile. When the equity market causes the mispricing, the option market follows due to the autoquote mechanism. Additionally, I use Monte Carlo to assess the suitability of the Hasbrouck (1995) Information Share and Gonzalo-Granger (1995) Component Share measures in the option-equity context. I find that neither metric is suitable, however the Putnins (2013) Information Leadership metric is and the options market has on average a 35% information leadership share.

Keywords: Options, Price Discovery, Market Microstructure

JEL Classification: G14

Suggested Citation

Kane, Hayden, Price Discovery Across Equity and Option Markets (September 4, 2014). Available at SSRN: https://ssrn.com/abstract=2325714 or http://dx.doi.org/10.2139/ssrn.2325714

Hayden Kane (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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