Testing the Efficiency of Indian Options Market

TABLE OF CONTENTS

Abstract

Table of Contents

List of Tables

Abbreviations

CHAPTER I INTRODUCTION
1.1 INTRODUCTION
1.2 GENESIS OF THE PROBLEM
1.3 MAJOR CONCEPTS
1.4 NEED FOR THE STUDY
1.5 OVERVIEW
1.6 CHAPTERIZATION

CHAPTER II REVIEW OF LITERATURE
2.1 INTRODUCTION
2.2 HOW REVIEW HAS BEEN CONDUCTED
2.3 STUDIES CONDUCTED ABROAD
2.4 STUDIES CONDUCTED IN INDIA

CHAPTER III RESEARCH METHODOLOGY
3.1 INTRODUCTION
3.2 STATEMENT OF THE PROBLEM
3.3 METHODOLOGY
3.4 VARIABLES USED
3.5 HYPOTHESES
3.6 SAMPLE SIZE
3.7 SOURCES OF THE DATA
3.8 SAMPLING TECHNIQUE
3.9 TESTS USED IN THE STUDY

CHAPTER IV INDUSTRY OVERVIEW
4.1 INTRODUCTION
4.2 OVEVIEW OF DERIVATIVES MARKET IN INDIA
4.3 GLOBAL DERIVATIVES MARKET
4.4 POLICY DEVELOPMENTS IN INDIA

CHAPTER V DATA ANALYSIS AND INTERPRETATION
5.1 INTRODUCTION
5.2 SECONDARY DATA ANALYSIS

CHAPTER V FINDINGS, CONCLUSION AND SUGGESTIONS
6.1 INTRODUCTION
6.2 DISCUSSION OF RESEARCH FINDINGS
6.3 CONCLUSION [0-9]+
6.4 SUGGESTIONS [0-9]+
6.5 IMPLICATIONS OF THE STUDY
6.6 LIMITATIONS OF THE RESEARCH
BIBLIOGRAPHY

ABSTRACT

The present study is conducted to test the efficiency of Indian options market. Very few studies have been conducted to test the efficiency of Indian derivatives market and especially Indian options market. This study is essential for testing the price discovery of the Indian options market. This study is motivated by lack of evidence and fills this gap by providing hitherto unavailable evidence on efficiency of the Indian options market.

The purpose of the study is to test the efficiency of Nifty stock options. The study is done using trading data for 1 month. Market efficiency is tested by examining the validity of the put-call parity and of the hedging strategy. Black-Scholes model of option pricing is used to determine the fair option prices in this study. In case of mispricing of options contracts, hedging test is conducted to ascertain whether above normal returns are possible by taking advantage of the mispricing.

In hedging test returns are calculated after the trader closes his position in the spot market. These returns are then compared to risk-free returns. When transaction costs are not taken into account, the hedging returns were more than the risk free returns for some stocks which showed that the market is inefficient. But after transaction costs are considered these returns became negative and ascertained that the market is efficient. Put- call parity test in the absence of the transaction costs showed that options market is inefficient. However in the presence of these costs, the hypothesis of market efficiency is accepted.

The present study will help to get useful insights so that the options markets can be made more efficient as healthy financial markets are backbone of any financially healthy country. Furthermore, financial markets should be efficient and efficiency helps to prevent any kind of frauds in the financial markets.

LIST OF TABLES

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ABBREVIATIONS

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CHAPTER I INTRODUCTION

1.1 INTRODUCTION

The present study is conducted to test the efficiency of Indian options market. This chapter highlights the importance and the need for the present study along with an overview about the methodology adopted in the study. This chapter starts with the genesis of the problem and the major concepts used in this study and ends with the chapterization i.e. what are the contents of the various chapters in the study.

1.2 GENESIS OF THE PROBLEM

The problem of the study is to test the efficiency of the Indian options market with respect to the Nifty stock options as underlying. An efficient financial market is one in which the prices of the financial instruments fully reflect all the available information. An efficient market also changes or adapts itself very fast so as to reflect the new information. Testing the efficiency of a financial market is very important because an efficient market is very much necessary for the “effective capital allocation, price discovery and risk management”. The efficiency of large financial markets is almost established. Such financial markets include forex markets in which it is almost impossible to earn supernormal profits by tapping arbitrage opportunities. Such markets adapt themselves so fast that it is almost impossible to earn riskless abnormal profits by making use of price differentials. Although options have been traded for many centuries but they are getting increased attention both in capital markets as an investment tool and in the development of the theory of capital assets valuations. Testing the efficiency of a market is also important because the growth of any financial market depends upon its efficiency. Thus efficiency of the options markets can be tested by testing the absence of arbitrage opportunities in a financial market.

An option is a contract in which the buyer of the option “a right” but not “an obligation” to buy or sell an underlying asset at the strike price on or before an expiration date. "A call option is the right to buy a given amount of a security at a given price on or before a specific date". The security involved in the call option is called the 'underlying security'. The price to be paid is called the “exercise price” or “strike price” and the specific date is called the “maturity date” or “expiration date”. The call option is an “European” call if it can only be exercised at maturity. It is known as an “American” call option if it can be exercised at any time on or before the “maturity date”. Options were traded in the Netherlands as early as the seventeenth century, during the Dutch tulip boom. In the UK, there was a well organised and sophisticated market for trading in puts and calls as early as the 1690s and in the US, the first mention of options in American history dated back to 1790. The options in the Indian financial markets are of “European” type and are settled on the cash basis.

Very few studies have been conducted till date to test the efficiency of the Indian financial markets and especially for the stock options market so the main aim of the study is to provide evidence for the efficiency of the Indian options market, by taking NSE’s Nifty stock options as underlying.

1.3 MAJOR CONCEPTS

The purpose of the study is to empirically test the efficiency of S&P CNX Nifty stock options. The study is done using intra- day trading data for 1 month. Market efficiency is tested by examining the validity of the put-call parity and of the hedging strategy. These are traditional static tests and are employed to account for various types of market frictions. The efficiency is tested in this study with the help of 'Riskless' hedging strategies using the Black-Scholes call option pricing model. Ex-post test was also conducted in the analysis in order to ascertain that whether the options are fairly priced or not. Fairly priced options show the lack of arbitrage opportunities in the options market. Ex-post test however is not “riskless”. Hence hedging tests were conducted. Hedging test involves closing the option position by taking an appropriate position in the spot market with the help of hedge ratio and then seeing whether abnormal returns are still possible or not. One of the chief advantages of these efficiency tests is that the possibility of arbitrage transactions is better when we use both the option and the underlying rather than just the option. The main benefit of the “no-arbitrage” approach to testing the efficiency of options market is that it does not rely on postulation about traders’ risk preference and dynamics of market prices. It only assumes that investors always desire more to less. As these arbitrage tests use only all the publically available information and the observed stock prices these test can be considered to test only the “weak form” of market efficiency. The efficiency is tested by taking into account transaction costs as well.

1.4 NEED FOR THE STUDY

Very few studies have been conducted to test the efficiency of Indian derivatives market and especially Indian options market. This study is essential for testing the price discovery of the Indian options market. The need for study is to find evidence that Indian options market is efficient. The study is conducted by studying S&P Nifty stock options. Previous studies of options market efficiency have been concentrated particularly on the Chicago Board Options Exchange, with a few later studies relating to the London, Toronto, Sydney and Amsterdam markets. This study is motivated by this lack of evidence and fills this gap by providing hitherto unavailable evidence on the efficiency of the Indian options market.

Some of the studies on the Indian derivatives market include “Investigating the Efficiency of Indian Equity Futures Market” by (Gupta & Singh, 2003) investigated the efficiency of price discovery of the Indian equity futures market but they could not conclude anything on the basis of short time dimension.

In the developed countries like U.S.A. and U.K., markets are found to be efficient but opposite often holds in case of the developing markets like India, Sri Lanka Taiwan, Bangladesh etc. If in emerging markets, option market is able to react to the market information readily, then, it will definitely help the supervisory body to control the volatility in the cash market and the confidence of the traders can be restored in a developing market like India, where people burnt their hands in early and mid 90’s due to the overwhelming participation in the market by single trader. Efficient price discovery in the options market has many advantages for the traders as well as for the regulators. Traders can manage their risk exposure in the cash market by taking reverse positions in the options market. In many stock markets it has been observed that the volatility in the cash market has reduced in the post options trading era as compared to the volatility in the pre options trading era. Reduction in the magnitude of volatility will certainly work for the benefit of all traders (both retail as well as big traders). Reduction in volatility ensures relatively stable price movements in the market, which will help the traders to take their decision in the market (subject to the experience and exposure of the trader in the market). The regulatory bodies can also be benefited through efficient price discovery in the options market. They can simulate the reforms through options market and then directly implement the same in the cash market. The reaction of the options market to such reforms will certainly help the regulatory bodies to evaluate the probability of success/failure of the reform in the cash market, thus they can make appropriate modifications, if necessary.

1.5 OVERVIEW

The present study is to done to test the efficiency of the Indian options market by taking S&P Nifty options as the underlying. The study is done using intra- day trading data for 1 month. Market efficiency is tested by examining the validity of the put-call parity and of the hedging strategy. These are traditional static tests and are employed to account for various types of market frictions. The efficiency is tested in this study with the help of 'Riskless' hedging strategies using the Black- Scholes call option pricing model.

The main benefit of the “no-arbitrage” approach to testing the efficiency of options market is that it does not rely on postulation about traders’ risk preference and dynamics of market prices. It only assumes that investors always desire more to less. As these arbitrage tests use only the publically available information and the observed stock prices these test can be considered to test only the “weak form” of market efficiency. The efficiency is tested by taking into account transaction costs as well. The efficiency is tested by taking into account transaction costs as well. The study is done by taking intraday trading data on S&P CNX Nifty stock options for 1 month.

1.6 CHAPTERIZATION

Chapter 1 is the introduction to the study which constitutes genesis of the problem, major concepts used in the study, need for the study and overview of the study as to how the study will be conducted. This chapter also consists of how the study will be useful and who all will benefit from the proposed study.
Chapter 2 consists of review of literature which consists of 29 reviews done on similar studies. It consists of a thorough review on the similar works along with a mention of how those studies were conducted i.e. the methodology used in those studies. It also consists of research gap which tells why the present study was necessary and tells about the differences between the existing studies and the proposed study.
Chapter 3 is Research Design. It consists of statement of the problem and variables used for the study i.e. the variables in the B-S model. It deals with the objective of the study as to what the present study is trying to achieve and the hypotheses taken in the present study. It also consists of the design of the study i.e the research method followed, sampling procedure, sources of data, explanation about the inputs and statistical tools used.
Chapter 4 is Data Analysis of the secondary data and the acceptance of the valid hypotheses. It consists of an overall explanation of how the study was conducted along with a suitable example. This chapter contains the interpretation of the results obtained by running the suitable tests on the collected data.
Chapter 5 is Findings, Conclusion and Suggestions. It highlights the main findings of the study, educational implications of the present study, limitations of the present study and suggestions for further studies. This chapter presents the conclusion obtained from the data interpretation and analysis.

CHAPTER II REVIEW OF LITERATURE

2.1 INTRODUCTION

Review of literature highlights the works similar to the proposed which have already been done. It gives details about the works already conducted and the conclusions presented by the various research scholars. Similar research may already have been conducted but it may not be on the same data set or same environment. Review of literature motivates the researcher to modify the research which has already been conducted and add a new dimension to it. It also guides the researcher and gives him/her an idea of as to how to approach a proposed study. The review of literature highlights the conflicting opinions of different research scholars and also explains how they reached those conclusions. It also highlights different statistical tests employed by the research scholars who have conducted similar research.

2.2 HOW REVIEWS HAVE BEEN DONE

This chapter deals reviews with the studies related to testing Option market efficiency. The tools and tests used in these studies are reviewed followed by a thorough study on how these studies were conducted i.e. the methodology followed in these studies. The review also highlights the educational implications of these studies along with their limitation.

2.3 STUDIES CONDUCTED ABROAD

Joo & How (1990), conducted a study on “Tests of Options Market Efficiency: A Study of European Options Exchange”. The purpose of this study is to provide an evidence for the efficiency of European Options Exchange. Hedging and “riskless” spreading strategies using the Black-Scholes option pricing model with dividend adjustment are used to test the efficiency of market in this paper. Appropriate estimators are chosen for the standard deviation of underlying stock’s return which is followed by the various types of tests in order to prove the Option market efficiency. The methodology also contains the criteria for determining the mispriced options and the method for calculating rate of return. Tools and tests used were Hedging Tests, Spreading Tests, Lower Boundary Condition Tests, Convexity Condition Tests, Put-Call Parity Tests, Volatility Tests, Black-Scholes Option Pricing Model. The results of this paper prove that, although for some cases in the absence of the transactions costs above normal returns are feasible, these returns become off-putting when we include the bid-ask spread cost. These results are consistent over the two sample periods studied in this paper. Two other variations of the trading rule that compute option prices by using the same model but with two different estimators of the standard deviation of the underlying stock's return as inputs to the model, also produce same results. The study proves that, with respect to the trading conventions used and the sample periods studied, the European Options Exchange was efficient and no inefficiencies exist. The study has been conducted very well and almost all the tests have been conducted in order to prove the efficiency of options market. The gap in this case is that this study is concerned with the European Options Exchange and results may not be true in case of Indian Options Market which is a emerging market. Other limitation of the study may be in the use of Black-Scholes model of Options Pricing as empirical studies show that Black-Scholes model values differ from the market values.

Bates (1995), conducted a study on “Testing Option Pricing Models”. The objective of this study is to discuss various option pricing models like Black- Scholes model, constant elasticity of variance model, stochastic volatility model and jump diffusion models. The methodology used in this study is the widespread survey on observed record on stock options, index options and index futures. Cross-sectional tests testing whether high-volatility stocks have high- priced options or not, GARCH Tests and arbitrage opportunity tests were conducted in this study. The conclusion of this study was that “implicit volatilities from most currency options are relatively unbiased forecasts of future currency volatility, whereas substantial biases have been found in the implicit volatilities from stock and stock index options” (Bates, 1995). The study focuses on the option pricing models whereas the present study is concerned with the efficiency of the options market.

Puttonen (1997), conducted a study titled “The Efficiency of the Finnish Equity Options and Futures Markets: A Review of Empirical Evidence”. The objective of this study is to go over the recent relevant research on the Finnish stock and stock index derivatives markets. First, the study briefly reviews the evolution of the Finnish derivatives markets. Then secondly, it reviews the studies that have examined whether “risk-free” arbitrage opportunities are possible or not. Thereafter, it presents a survey on these studies concerning the informational efficiency of the Finnish equity index options and futures markets. Tools and tests used in this study are boundary tests, put-call parity tests. The study supports the efficiency of Finnish options market. The study may not be applicable to Indian options market.

Los (1998), conducted a study titled “Nonparametric Efficiency Testing of Asian markets using weekly data”. The objective of this research study was to test the efficiency of Asian Markets like Thailand, Indonesia and Malaysia. The efficiency of stock markets, as represented by “Fama's 1970 fair game model”, is tested on weekly price index data of six Asian stock markets like Hong Kong, Indonesia, Malaysia, Singapore, Taiwan and Thailand - using Sherry's (1992) non-parametric methods. These tests clearly show that all six stock markets lacked at least one of the two required fair game attributes, and, accordingly, “Fama's Efficient market Hypothesis” must be rejected for these Asian markets. However, Singapore financial market proved to be the most efficient regional Asian stock market. A tentative ranking of the stock markets according to this study in order of stock market efficiency is: Singapore, Thailand, Indonesia, Malaysia, Hong Kong and Taiwan. Singapore's stock market proved to be the most efficient and can support efficient trading of stock options. The tests show both Hong Kong and Taiwan to be inefficient markets. The study does not take into account Indian markets.

Frangoulis, P, & Paris (1999), conducted a study titled “Market Efficiency & Arbitrage opportunities in the FTSE-100 option market: An Application on the Put-Call Parity with High Frequency Data.” The objective of this thesis is to examine Put Call Parity (PCP) deviations in the LIFFE FTSE-100 Options quoting system and thereby test the efficiency of FTSE-100 option market. The Study calculates PCP mispricing using the model proposed in Kamara and Miller (1995). The model used here accommodates market imperfections but does not include taxes. The model also allows for the immediacy risk and the early exercise risk associated with evidence of Put-Call Parity deviations documented in the literature. Test used in this study is Put- call parity test. The study concludes that the market is not inefficient and even if the inefficiencies exist they are short­lived. The research gap is that the study is biased towards showing that the inefficiencies exist in the market.

Mammola & Cavallo (2000), conducted a study titled “Empirical tests of efficiency of the Italian index options market” .The objective of this study is to test whether Italian index option contract MIBO30 is efficiently priced or not. In this Study two different methods were used to analyse the same. First, the Study tests the validity of the put-call parity conditions on the index options, comprehensively to account of transaction costs associated with duplicating and establishing a short hedge on the index. The Study further investigates the likelihood of generating profitable positions through by simulating ex-post volatility hedging strategy. Tools and tests used in this study are Put-Call Parity test, ex- post volatility hedging strategy. The Study supports the hypothesis that options are efficiently priced and MIBO30 index option is consistent with the market efficiency. The research gap is that the Study is that it is only limited to the Italian Index option contract MIBO30. The result of the study may not hold true in the case of Indian Options Market.

Ackert & Tian (2000), conducted a study titled “Evidence on the Efficiency of Index Options Market”. The objective of this study is to study the index option pricing models and to provide a proof for the efficiency of Index Options Market. In this study the efficiency of the S&P 500 index options market is tested using theoretical pricing relationships derived from stock index option “no-arbitrage” principles. The methodology used in this study is the analysis of previous studies on the arbitrage pricing relationships of the options and thereby followed by conducting various tests to test the efficiency of index options market. Tools and tests used in this study are spreading Tests, Lower Boundary Condition Tests, Convexity Condition Tests, Put-Call Parity Tests. This study shows that violations have been reported in the box- spread relationships even after including transaction costs. The result of the study shows that some arbitrage opportunities are present and the markets are not perfectly efficient. The study seems to be biased as it focuses more on proving that the tests are violated. It also focuses only on those studies which show that no- arbitrage conditions have been violated.

Capelle-Blancard & Choudhary (2001), conducted a study titled “Efficiency Tests of the French Index (CAC 40) Options Market". The purpose of this research study is to inspect whether the French options market “(MONEP)” is efficient or not. The study is conducted using transaction data on CAC 40 index options during the period January 02, 1997 to December 30, 1999. The objective of this study is to empirically test the efficiency of a comparatively new yet important and growing market, the French options market “MONEP”. More precisely, the purpose is to study the efficiency of the market for options of the well-known French stock index “CAC 40” with the help of intra-day data during January 2, 1997 through December 30, 1999. Several no arbitrage conditions were tested in this study on the transaction data on CAC 40 Index options of about two years. Tools and tests used were spreading Tests, Lower Boundary Condition Tests, Convexity Condition Tests, Put-Call Parity Tests. The study concludes that MONEP is efficient as the frequency of arbitrage condition contravention is very less. The study finds some proof although not decisive that arbitrage opportunities are more common during periods of fast index options trading. The study does not take into account Hedging Tests. Hence we can say that the tools used are not sufficient. The study is concerned with the French Index Options whereas the present study is concerned with Indian Options Market. Hence the results of this study may not be true for the present study.

Ahn (2001), conducted a study titled “Arbitrage Opportunities and Efficiency of an Emerging Option Market: The Case of KOSPI 200 Options in Korea”. This study investigates arbitrage opportunities and efficiency of the KOSPI 200 options in Korea, a developing but one of the fastest growing and the most actively traded index option market in the world. Numerous “no-arbitrage” conditions are considered in this study including lower boundary conditions of call and put prices, option price relations independent of underlying index, put-call parity, and box spread arbitrage conditions. Tools used in this study are boundary condition tests, put-call parity tests. The study concludes, “there exist sizable arbitrage opportunities when the arbitrage conditions involve both options and the underlying index” (Ahn, 2001). However, few arbitrage opportunities exist when the arbitrage conditions are formed independent of the underlying index. The study deals with kospi index options. The results may not be applicable in case of Indian Options market which is relatively new and belongs to a emerging economy.

Hogana, Jarrow, Teoc & Warachka (2003), conducted a study titled “Testing Market Efficiency using Statistical Arbitrage with Applications to Momentum and Value Strategies”. The objective of this study is to prove whether statistical arbitrage is possible or not in the market. The theory of “statistical arbitrage” is used in this paper. “Statistical arbitrage is a long horizon trading opportunity that generates a riskless profit” (Hogana, Jarrow, Teoc, & Warachka, 2003). As such, statistical arbitrage is a natural extension of the trading strategies utilized in the existing empirical literature on persistent. Statistical test is used to establish whether a trading strategy constitutes “statistical arbitrage” based on its incremental trading profits computed over short time horizons is used. The test is conducted on the transaction data. The findings of the study show that the application of momentum and value strategies generate “statistical arbitrage” even after adjusting for transaction costs. This study tests for the presence of “statistical arbitrage” in the stock market and does not really deal with the presence of arbitrage in the options market. This study does not apply traditional tests for testing the efficiency of the options market.

Pierides (2004) conducted a study titled “Affirming Market Efficiency of the Athens Derivatives Exchange via Traditional Static Arbitrage Tests”. The purpose of this study is to examine the existence of arbitrage opportunities prevailing in the Athens Derivatives Exchange (ADEX). The study investigates the validity of the put-call parity and box spreads in the existence of various forms of market frictions. Market efficiency is tested in this study by examining the validity of the put-call parity and of the box spread strategy. These are traditional static tests and are employed to account for various types of market frictions. Tests used in this study are put-Call Parity tests , Box-Spread tests. The study’s results lead to the conclusion that the FTSE/ASE-20 Index options offered various forms of arbitrage opportunities to low cost traders. It is found that a form of ADEX inefficiency could have allowed market makers to exploit considerable arbitrage opportunities, mainly because they face significant low transaction fees. The box spread parity test revealed that substantial and economically meaningful arbitrage opportunities were present during the early trading history of ADEX. The Study test the efficiency of Athens Derivative Exchange which is relatively new and thus various arbitrage opportunities are available as it is not efficient but this may not be true in the case of Indian Options Market.

Gillette & Lindsay (2005), conducted a study titled “An Empirical Test of German Stock Market Efficiency”. The aim of this research study is to test the efficiency of German Stock Market. In this paper a multifactor stock screening method called “CAN SLIM” has been applied, “CAN SLIM” has recorded highly positive abnormal returns in the U.S., to the German market. The study supports the efficiency of German stock market. The study is only confined to stock market and does not test the efficiency of options market.

Kenourgios & Dimitris (2005), conducted a study titled “Testing efficiency and the unbiasedness hypothesis of the emerging greek futures market”. This paper investigates the joint hypothesis of market efficiency and unbiasedness of futures prices for the FTSE-20 blue chip index futures contract. Johansen cointegration test is used to test the efficiency of the futures contract. Test used in this study is Johansen cointegration test. The Johansen cointegration procedure usedto test the market efficiency shows that the joint hypothesis of market efficiency and unbiasedness in futures prices is rejected, indicating market inefficiency. This study deals with the efficiency of futures market and not options market.

Li (2006), conducted a study titled “The Arbitrage Efficiency of the Nikkei 225 Options Market: A Put-Call Parity Analysis”. This paper is concerned with arbitrage efficiency of the Nikkei index option contracts traded on the Osaka Securities Exchange (OSE) within the put-call parity (PCP) framework.

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