The Derivative Payoff Bias
71 Pages Posted: 20 Sep 2023 Last revised: 30 May 2024
Date Written: September 6, 2023
Abstract
A significant fraction of U.S. equity index derivatives expire "a.m." on the 3rd Friday of each month via constituent stocks' opening trade price. We show these prices are biased upwards since the advent of overnight trading in the early 2000s. Equity prices drift up from Thursday close to 3rd Friday open and revert at the point derivative payoffs are calculated. As a result, equity futures and call option payoffs are biased upwards, while put option payoffs are biased downwards, generating a wealth transfer of ~$3.5 billion per year in S&P 500 index options alone. Exploring explanations, we show that a novel channel ("charm'') originating from market makers' hedging practices represents a plausible explanation for the derivative payoff bias.
Keywords: Stocks, Derivatives, Futures, Market Microstructure, Market Design
JEL Classification: G10, G12, G13, G14
Suggested Citation: Suggested Citation