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Mispricing of Index Options with Respect to Stochastic Dominance Bounds?

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  • Wallmeier, Martin

Abstract

For one-month S&P 500 index options, Constantinides et al (2009) report widespread and substantial violations of stochastic dominance bounds. According to the subsequent study of Constantinides et al (2011), the violations can be exploited to generate abnormal trading profits. The reported mispricing, which is far more extreme than known from the pricing kernel puzzle, calls into question that option markets meet the most basic requirements of rational pricing. However, we find that index options on the S&P 500, EuroStoxx 50 and DAX are priced almost perfectly in line with stochastic dominance bounds when adjusting for (a) the general level of option prices, (b) conditional volatility and (c) put-call parity in order to determine the appropriate (dividend-adjusted) underlying index level. Our results indicate that index option markets might be much more efficient than previous literature suggests.

Suggested Citation

  • Wallmeier, Martin, 2021. "Mispricing of Index Options with Respect to Stochastic Dominance Bounds?," Critical Finance Review, now publishers, vol. 10(1), pages 21-55, April.
    • Handle: RePEc:now:jnlcfr:104.00000089
    DOI: 10.1561/104.00000089
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    Cited by:

    1. Martin Wallmeier, 2024. "Quality issues of implied volatilities of index and stock options in the OptionMetrics IvyDB database," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 44(5), pages 854-875, May.

    More about this item

    Keywords

    Index options; Stochastic dominance; Volatility smile; Implied volatility;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • G24 - Financial Economics - - Financial Institutions and Services - - - Investment Banking; Venture Capital; Brokerage

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