An empirical analysis of market efficiency in Indian options market

Abstract

Equity derivatives market in India has registered an explosive growth and is expected to continue the same in the years to come. Introduced in the year 2000, financial derivatives market in India has shown a remarkable growth both in terms of volumes and numbers of contracts traded. The National Stock Exchange of India Limited (NSE) commenced trading in derivatives with the launch of index futures on June 12, 2000. The futures contracts are based on the popular benchmark S&P CNX Nifty Index. The Exchange introduced trading in Index Options (also based on Nifty) on June 4, 2001. NSE also became the first exchange to launch trading in options on individual securities from July 2, 2001. Futures on individual securities were introduced on November 9, 2001. Futures and Options on individual securities are available on 223 securities stipulated by SEBI. The National Stock Exchange (NSE) alone accounts for 99 percent of the derivatives trading in Indian markets. For example, in 2010-11 (till 31st Jan 2011), the value of the NSE derivatives markets was Rs. 2,63,70,320.92 Crores (US $ 5,860 Billion) whereas the value of the NSE cash markets was only Rs. 35,51,038 Crores (US $ 789.1 Billion)i. The average daily turnover in the F&O Segment of the Exchange during 2009-10 was ` 72,392 crore (US $ 16,097 million). However these figures are still miniscule compared to markets in advanced economies. The markets in these advanced economies have developed a certain level of maturity which makes them very efficient and thereby difficult to pawn upon to leverage arbitrage opportunities. The Indian derivatives market on the other hand is still in a certain stage of infancy and it is quite possible that such arbitrage opportunities do exist here. On performing further classification, futures market (65% Turnover) is considerably bigger than the options market (35% Turnover)ii. Currently NSE provides 233 stocks for futures and options trading. The same number for the Bombay Stock Exchange (BSE) is just about half at 109 stocks. Out of 233 stocks, there are only 20 odd stocks which have more than 500 options contract traded in a day. The rest suffer from low or no trade on any given day and thus they might trade at non-standardized prices, often being dependent on the leverage of the buyer or the seller. Thus, it is quite possible that the prices existing in the market are going to provide arbitrage opportunities which can be exploited using relevant trading strategies. Arbitrage in options can be present due to market inefficiencies which affect pricing. In the project we are trying to address some key issues which affect the pricing of these exchange traded options contract. All these inefficiencies are violation of the Black Scholes Pricing Model which is one of the most used models around the world to price options. One of the main reason which affects pricing is Liquidity Risk. Standard asset pricing theory assumes that the market is frictionless and competitive and thus liquidity is not priced. However, once these assumptions are relaxed, the standard theory may not be readily applicable. For instance, it has already been well documented within the market microstructure literature that liquidity factors are important determinants of stock and bond returns. Such returns have been found to be affected by liquidity, as measured by the bid-ask spread. Second key issue is "No Short Selling" iiiof stocks for long term. In India, individual investors are allowed to net off their trades on the same day. That is, a retail or high Networth investor can buy 1000 shares of ACC and sell them, or a reverse transaction, the same trading day. But institutional investors—domestic and foreign—are forbidden from netting off their trades' intraday. This should have considerable effect on the pricing of options using stocks. A solution is to price options using futures as they can be shorted. We will try to understand what parameters are used in India to price options by doing option pricing ourselves and try to get more insights about what is the term of volatility used for pricing. Thirdly we will also try to understand the variations in the implied volatility or Calls and Puts. It is important to understand this because if implied volatility levels are not same there can be arbitrage due to under pricing or overpricing of other.