RFS Advance Access originally published online on February 21, 2008
Review of Financial Studies 2009 22(3):1247-1277; doi:10.1093/rfs/hhn009
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Mispricing of S&P 500 Index Options
University of Chicago and NBER
University of Konstanz
Concordia University
Address correspondence to George M. Constantinides, Graduate School of Business, University of Chicago, 5807 S. Woodlawn Avenue, Chicago, IL 60637; telephone: 773-702-7258; e-mail: gmc{at}ChicagoGSB.edu.
JEL Classification: G10, G13
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Abstract |
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Widespread violations of stochastic dominance by 1-month S&P 500 index call options over 1986–2006 imply that a trader can improve expected utility by engaging in a zero-net-cost trade net of transaction costs and bid-ask spread. Although precrash 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. Substantial violations by postcrash OTM calls contradict the notion that the problem lies primarily with the left-hand tail of the index return distribution and that the smile is too steep. The decrease in violations over the postcrash period of 1988–1995 is followed by a substantial increase over 1997–2006, which may be due to the lower quality of the data but, in any case, does not provide evidence that the options market is becoming more rational over time.
We thank workshop participants at the German Finance Society Meetings 2004; the Bachelier 2004 and 2006 Congresses; the FMA 2005 European Conference; the EFA 2005 Meetings; the Frontiers of Finance Conference 2006; the Alberta/Calgary 2006 Conference; the Universities of Chicago, City, Concordia, Frankfurt, Iowa, Laval, Maryland, Princeton, Southern California, Svizzera Italiana, Texas-Austin, Torino, St. Gallen, Utah, and New York; London Business School; London School of Economics; and, in particular, Yacine Aït-Sahalia, David Bates, Duke Bristow, Larry Harris, Steve Heston, Jim Hodder, Mark Loewenstein, Matthew Richardson, Jeffrey Russell, Hersh Shefrin, Greg Willard, and the referees for their insightful comments and constructive criticism. We also thank Michal Czerwonko for excellent research assistance. We remain responsible for errors and omissions. Constantinides acknowledges financial support from the Center for Research in Security Prices of the University of Chicago, and Perrakis from the Social Sciences and Humanities Research Council of Canada.
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