Indian equity options: Smile, risk premiums, and efficiency

Abstract

We study the pricing of equity options in India which is one of the world's largest options markets. Our findings are supportive of market efficiency: A parsimonious smile‐adjusted Black model fits option prices well, and the implied volatility (IV) has incremental predictive power for future volatility. However, the risk premium embedded in IV for Single Stock Options appears to be higher than in other markets. The study suggests that even a very liquid market with substantial participation of global institutional investors can have structural features that lead to systematic departures from the behavior of a fully rational market while being “microefficient.”

Rational repricing of risk during COVID‐19: Evidence from Indian single stock options market

“…Christensen and Prabhala ( 1998 ) showed that implied volatility outperforms historical volatility in forecasting future volatility. Since then, other researchers have confirmed the evidence across markets (Poon & Granger, 2003 ), including for India (Jain et al, 2019 ; Panda et al, 2008 ).…”

“…The options price reflects the uncertainty over the option's remaining life and not the uncertainty observed in the past. It is well established in the literature that globally implied volatility from the options market leads the realized volatility (Christensen & Prabhala, 1998 , Poon & Granger, 2003 ), and this has been verified in India as well (Jain et al, 2019 ).…”

“…For fitting the daily volatility smiles for the SSO and the index options, we use the same methodology as used in Jain et al ( 2019 ). For this, we first filter out the illiquid SSO contracts by removing all contracts that traded less than five times during a day and then construct the smile only for those underlying stock‐day where we have at least five liquid contracts being traded on the underlying stocks.…”

“…There is a literature gap on how the pandemic impacted volatility, skewness, and kurtosis in emerging market stock indices. We use information from SSO traded on India's National Stock Exchange (NSE), a market unique among other emerging markets in having both liquid futures and options contracts on the same underlying (Jain et al, 2019 ). Through the onset of the pandemic and ensuing government‐imposed lockdowns, our study uses measures of uncertainty that go beyond capturing changes in the market‐wide level of implied volatility (captured by measures like VIX), and include variables that quantify the relative difference in left and right tail risks and the convexity of volatility at the stock level.…”

“…Both the single stock and the index options that trade at NSE are European. In a recent study, Jain et al ( 2019 ) found that the Indian equity options market is microefficient with low relative mispricing.…”