Market imperfection and pricing in Korean derivative markets

Abstract

This study investigates price anomalies by examining market dynamics and price formation process in derivative markets. Firstly, we examine the effect of transaction costs on volatility smile phenomenon in option market, one of the famous financial anomalies. In addition, we investigate the effect of transaction costs on parameter estimation, and hedging of options. Using simulations, we document that transaction costs can generate the volatility smile phenomena even in the Black-Scholes economy. Particularly, volatility smile effect is very strong for short-term options and it disappears as the maturity of options becomes longer. Transaction costs cannot reject the true model falsely. All the parameter values that are supposed to be zero are not statistically significant even in the presence of transaction costs. In hedging, the Black-Scholes model performs better than any other model in any case. This may result from the parameter instability of the cross-sectional estimation method. Secondly, we examine the price effect of information asymmetry and informed investors’ preference on option market. To do this, we investigate the information impacts of net buying pressure on implied volatility and the intraday relation between index and option markets, using the intraday data of the KOSPI 200 index option market. We observe that the net buying pressure of call (put) options raises implied volatilities of calls (puts), while the net buying pressure of put (call) options lowers implied volatilities of calls (puts), Moreover, we document that the net buying pressure in the option market leads the stock market return. These results suggest that option traders in the KOSPI 200 index option market are directional traders informed by future index price movement rather than volatility traders informed by future index volatility, and also support the learning hypothesis rather than the limit of arbitrage hypothesis of Bollen and Whaley (2004) on the U.S. option mar...