Working Paper: NBER ID: w14544
Authors: George M. Constantinides; Jens Carsten Jackwerth; Stylianos Perrakis
Abstract: Widespread violations of stochastic dominance by one-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 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. Substantial violations by post-crash OTM calls contradict the notion that the problem primarily lies with the left-hand tail of the index return distribution and that the smile is too steep. The decrease in violations over the post-crash period 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.
Keywords: S&P 500; options; mispricing; stochastic dominance; Black-Scholes-Merton
JEL Codes: G12; G13
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| widespread violations of stochastic dominance in S&P 500 index options (G40) | traders can improve expected utility through zero-net-cost trades (D11) |
| pre-crash option prices conform reasonably well to the BSM model (G13) | post-crash option prices are incorrectly priced (G13) |
| market conditions and transaction costs (G19) | rationality of option pricing (G13) |
| stochastic dominance violations (D81) | at least one trader can increase expected utility by trading (D11) |
| decrease in violations from 1988 to 1995 (K42) | increase from 1997 to 2006 (C80) |