Mispricing of S&P 500 Index Options

49 Pages Posted: 24 Feb 2005

See all articles by George M. Constantinides

George M. Constantinides

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Jens Carsten Jackwerth

University of Konstanz - Department of Economics

Stylianos Perrakis

Concordia University, Quebec - John Molson School of Business

Multiple version iconThere are 3 versions of this paper

Date Written: November 10, 2006

Abstract

We document widespread violations of stochastic dominance by one-month S&P 500 index call options market over 1986-2006. These violations imply that a trader can improve her expected utility by engaging in a zero-net-cost trade. We allow the market to be incomplete and also imperfect by introducing transaction costs and bid-ask spreads. Even though pre-crash 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 even with a variety of statistical adjustments. Even though there are fewer violations by OTM calls than by ITM calls, there are still substantial violations by OTM calls, contradicting the inference drawn from the observed implied volatility smile that the problem primarily lies with the left-hand tail of the index return distribution. Most of the violations by post-crash options are not due to the smile being too steep: options are underpriced over 1988-1995 and overpriced over 1997-2006. The decrease in violations over the post-crash period 1988-1995 is followed by a substantial increase in violations over 1997-2006. These results do not support the hypothesis that the options market is becoming more rational over time.

Keywords: Derivative pricing; volatility smile, incomplete markets, transaction costs; index options; stochastic dominance bounds

JEL Classification: G13

Suggested Citation

Constantinides, George M. and Jackwerth, Jens Carsten and Perrakis, Stylianos, Mispricing of S&P 500 Index Options (November 10, 2006). EFA 2005 Moscow Meetings. Available at SSRN: https://ssrn.com/abstract=671565 or http://dx.doi.org/10.2139/ssrn.671565

George M. Constantinides

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
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773-702-7258 (Phone)
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National Bureau of Economic Research (NBER)

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Jens Carsten Jackwerth (Contact Author)

University of Konstanz - Department of Economics ( email )

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Konstanz, 78457
Germany
+497531882196 (Phone)
+497531883120 (Fax)

HOME PAGE: http://cms.uni-konstanz.de/wiwi/jackwerth/

Stylianos Perrakis

Concordia University, Quebec - John Molson School of Business ( email )

1455 de Maisonneuve Blvd. W.
Montreal, Quebec H3G 1M8
Canada

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