IDEAS home Printed from https://ideas.repec.org/a/eee/reveco/v89y2024ipbp159-171.html
   My bibliography  Save this article

Uncertainty measure: As a proxy for the degree of market imperfection

Author

Listed:
  • Zhang, Hailiang
  • Sattar, Muhammad Atif
  • Wang, Haijun

Abstract

This study makes a significant contribution to the existing literature on the concept of the “degree of imperfection between markets” and its evaluation model, which was originally developed by Wang and Hsu in 2004. By further expanding upon this foundational framework, Hsu (2010) established that the degree of imperfection between markets also applies within a market and can be operationalized in option markets. With these insights as a basis, this study formulates hypotheses to examine the relationship between the degree of imperfection and three key variables: the absolute error (AE) of call prices, the absolute error (AE) of implied volatility, and uncertainty. The empirical results of the hypothesis reveal a positive association between the degree of imperfection and the AE of call price, AE of implied volatility, and uncertainty. Moreover, the Study introduces Shannon entropy as a measure of uncertainty, and establishes uncertainty as a viable proxy for quantifying the degree of imperfection.

Suggested Citation

  • Zhang, Hailiang & Sattar, Muhammad Atif & Wang, Haijun, 2024. "Uncertainty measure: As a proxy for the degree of market imperfection," International Review of Economics & Finance, Elsevier, vol. 89(PB), pages 159-171.
    • Handle: RePEc:eee:reveco:v:89:y:2024:i:pb:p:159-171
    DOI: 10.1016/j.iref.2023.09.013
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S1059056023003684
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.iref.2023.09.013?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Saurabh Mishra & Bilal M. Ayyub, 2019. "Shannon Entropy for Quantifying Uncertainty and Risk in Economic Disparity," Risk Analysis, John Wiley & Sons, vol. 39(10), pages 2160-2181, October.
    2. Figlewski, Stephen, 1989. " Options Arbitrage in Imperfect Markets," Journal of Finance, American Finance Association, vol. 44(5), pages 1289-1311, December.
    3. Oksana MYKHAILOVSKA, 2014. "The Nature Of Entropy In Socio-Economic Systems," EcoForum, "Stefan cel Mare" University of Suceava, Romania, Faculty of Economics and Public Administration - Economy, Business Administration and Tourism Department., vol. 3(1), pages 1-9, January.
    4. Christoffersen, Peter & Jacobs, Kris, 2004. "The importance of the loss function in option valuation," Journal of Financial Economics, Elsevier, vol. 72(2), pages 291-318, May.
    5. Byounghyun Jeon & Sung Won Seo & Jun Sik Kim, 2020. "Uncertainty and the volatility forecasting power of option‐implied volatility," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 40(7), pages 1109-1126, July.
    6. Baltussen, Guido & van Bekkum, Sjoerd & van der Grient, Bart, 2018. "Unknown Unknowns: Uncertainty About Risk and Stock Returns," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 53(4), pages 1615-1651, August.
    7. Les Gulko, 1997. "Dart Boards And Asset Prices," Advances in Econometrics, in: Applying Maximum Entropy to Econometric Problems, pages 237-276, Emerald Group Publishing Limited.
    8. Janchung Wang & Hsinan Hsu, 2006. "Degree of market imperfection and the pricing of stock index futures," Applied Financial Economics, Taylor & Francis Journals, vol. 16(3), pages 245-258.
    9. Shternshis, Andrey & Mazzarisi, Piero & Marmi, Stefano, 2022. "Measuring market efficiency: The Shannon entropy of high-frequency financial time series," Chaos, Solitons & Fractals, Elsevier, vol. 162(C).
    10. Yun Yin & Peter G. Moffatt, 2019. "Correcting the Bias in the Practitioner Black-Scholes Method," JRFM, MDPI, vol. 12(4), pages 1-12, September.
    11. Hsinan Hsu & Janchung Wang, 2004. "Price Expectation and the Pricing of Stock Index Futures," Review of Quantitative Finance and Accounting, Springer, vol. 23(2), pages 167-184, September.
    12. Philippatos, George C & Wilson, Charles J, 1974. "Information theory and risk in capital markets," Omega, Elsevier, vol. 2(4), pages 523-532, August.
    13. Janchung Wang, 2008. "Degree of market imperfections: evidence from four Asian index futures markets," Applied Financial Economics, Taylor & Francis Journals, vol. 18(15), pages 1233-1246.
    14. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    15. Bernard Dumas & Jeff Fleming & Robert E. Whaley, 1998. "Implied Volatility Functions: Empirical Tests," Journal of Finance, American Finance Association, vol. 53(6), pages 2059-2106, December.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    2. Dennis Bams & Thorsten Lehnert & Christian C. P. Wolff, 2009. "Loss Functions in Option Valuation: A Framework for Selection," Management Science, INFORMS, vol. 55(5), pages 853-862, May.
    3. Bernales, Alejandro & Guidolin, Massimo, 2014. "Can we forecast the implied volatility surface dynamics of equity options? Predictability and economic value tests," Journal of Banking & Finance, Elsevier, vol. 46(C), pages 326-342.
    4. Lin, Xiaoqiang & Chen, Qiang & Tang, Zhenpeng, 2014. "Dynamic hedging strategy in incomplete market: Evidence from Shanghai fuel oil futures market," Economic Modelling, Elsevier, vol. 40(C), pages 81-90.
    5. Chalamandaris, Georgios & Tsekrekos, Andrianos E., 2009. "Common Factors and Causality in the Dynamics of Implied Volatility Surfaces: Evidence from the FX OTC Market," The Journal of Economic Asymmetries, Elsevier, vol. 6(1), pages 49-74.
    6. Guidolin, Massimo & Wang, Kai, 2023. "The empirical performance of option implied volatility surface-driven optimal portfolios," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 618(C).
    7. Vipul Kumar Singh, 2013. "Effectiveness of volatility models in option pricing: evidence from recent financial upheavals," Journal of Advances in Management Research, Emerald Group Publishing Limited, vol. 10(3), pages 352-375, October.
    8. Le, Van & Zurbruegg, Ralf, 2014. "Forecasting option smile dynamics," International Review of Financial Analysis, Elsevier, vol. 35(C), pages 32-45.
    9. Janis Bauer & Holger Fink & Eva Stoller, 2020. "Are Issuer Margins Fairly Stated? Evidence from the Issuer Estimated Value for Retail Structured Products," Forecasting, MDPI, vol. 2(4), pages 1-23, September.
    10. Hsinan Hsu & Hsing-Chi Wu & Hsien-Yi Lee & Janchung Wang, 2010. "A measurement of the extent of market imperfections between markets and applications," Applied Economics, Taylor & Francis Journals, vol. 42(16), pages 2111-2126.
    11. Andreou, Panayiotis C. & Charalambous, Chris & Martzoukos, Spiros H., 2010. "Generalized parameter functions for option pricing," Journal of Banking & Finance, Elsevier, vol. 34(3), pages 633-646, March.
    12. Pascal François & Lars Stentoft, 2021. "Smile‐implied hedging with volatility risk," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 41(8), pages 1220-1240, August.
    13. Kaeck, Andreas & Seeger, Norman J., 2020. "VIX derivatives, hedging and vol-of-vol risk," European Journal of Operational Research, Elsevier, vol. 283(2), pages 767-782.
    14. Carol Alexander & Andreas Kaeck, 2012. "Does model fit matter for hedging? Evidence from FTSE 100 options," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 32(7), pages 609-638, July.
    15. Liu, Xiaoquan & Cao, Yi & Ma, Chenghu & Shen, Liya, 2019. "Wavelet-based option pricing: An empirical study," European Journal of Operational Research, Elsevier, vol. 272(3), pages 1132-1142.
    16. Peter Christoffersen & Kris Jacobs & Karim Mimouni, 2007. "Models for S&P500 Dynamics: Evidence from Realized Volatility, Daily Returns, and Option Prices," CREATES Research Papers 2007-37, Department of Economics and Business Economics, Aarhus University.
    17. Hsinan Hsu & Yaw-Bin Wang, 2009. "Feasibility of riskless hedged portfolios in imperfect markets," Applied Economics Letters, Taylor & Francis Journals, vol. 16(11), pages 1149-1153.
    18. Carol Alexander & Alexander Rubinov & Markus Kalepky & Stamatis Leontsinis, 2012. "Regime‐dependent smile‐adjusted delta hedging," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 32(3), pages 203-229, March.
    19. Gurupdesh S. Pandher, 2007. "Regression-based modeling of market option prices: with application to S&P500 options," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 26(7), pages 475-496.
    20. Yunbi An & Wulin Suo, 2009. "An Empirical Comparison of Option‐Pricing Models in Hedging Exotic Options," Financial Management, Financial Management Association International, vol. 38(4), pages 889-914, December.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:reveco:v:89:y:2024:i:pb:p:159-171. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/620165 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.