Evidence on the efficiency of index options markets

Index options have been one of the most successful of the many innovative financial instruments introduced over the last few decades, as their high trading volume indicates. Given their prominence, the pricing efficiency of these markets is of great importance. ; Detecting inefficient pricing, or mispricing, requires comparing a theoretically efficient price with prices of options traded in financial markets. One popular approach to deriving pricing relationships is based on a principle called no-arbitrage, which simply assumes that arbitrageurs enter the market and quickly eliminate mispricing if a profit opportunity without risk exists. However, in a well-functioning economy there is no such opportunity; arbitrage is critical for ensuring market efficiency. ; The authors analyze earlier evidence that has been taken to indicate that options markets are inefficient and that casts doubt on whether options markets contribute to price discovery, hedging, and efficient capital allocation. The article presents new evidence on index option pricing, examining arbitrage strategies that do not involve trading a stock index and relationships that hold for any given value of the underlying asset. This approach avoids some of the difficulties that can arise from impediments to arbitrage. The article also examines the efficiency of the market for the popular Standard and Poor's 500 index options. While the results indicate that these options are frequently mispriced, the mispricing may not indicate market inefficiency because there are limits to arbitrage.