Transaction Costs and Stochastic Dominance Efficiency in the Index Futures Options Market
45 Pages Posted: 16 Mar 2006
Date Written: March 2006
This paper examines the stochastic dominance efficiency in the presence of transaction costs for S&P 500 index futures call and put options by estimating bounds on reservation write and reservation purchase prices and then verifying whether the observed option prices satisfy them. The bounds are estimated from data on past realizations of the underlying asset and under various data-based assumptions about the investor-assumed distribution of that asset. The bounds are then compared to observed market prices and several violations are identified under all distributional assumptions, although these violations are relatively few under forward-looking distributions. The paper then derives trading strategies that exploit these violations and increase expected utility for any risk averse investor. It develops a metric that evaluates the increase in expected utility for any given investor within a certain utility class and links it with the traditional second degree stochastic dominance criterion. Last, it demonstrates by out-of-sample tests with realized underlying asset prices that these strategies to exploit the mispricing of index futures options do indeed improve risk-adjusted returns for risk averse investors.
Keywords: Derivatives pricing, Transaction costs, Stochastic dominance, Index options, Futures options
JEL Classification: G11, G12, G13, G14
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