Indian Single Stock Option Pricing

A recent paper by my doctoral student, Sonali Jain, my colleague, Prof. Sobhesh Agarwalla and myself (Jain S, Varma JR, Agarwalla SK. Indian equity options: Smile, risk premiums, and efficiency. J Futures Markets. 2018;1–14. https://doi.org/10.1002/fut.21971) studies the pricing of single stock 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.”

The good news here is that (a) options with different strikes on the same stock are nicely consistent with each other (parsimonious smile), and (b) the option market predicts future volatility instead of blindly extrapolating past volatility. The troubling part is that the implied volatility of Indian single stock options consistently exceeds realized volatility by too large an amount to be easily explained as a rational risk premium. Globally, there is a substantial risk premium in index options but not so much in single stock options in accordance with the intuition that changes in index volatility are a non diversifiable risk, while fluctuations in the idiosyncratic volatility of individual stocks are probably diversifiable. The large gap between Indian implied and realized volatility is therefore problematic. However, the phenomenon cannot be attributed entirely to an irrational market: we find that the single stock implied volatility has a strong systematic component responding to changes in market wide risk aversion (the index option smile).

There is a puzzle here that demands further research. There is some anecdotal evidence that option writers demand a risk premium for expiry day manipulation by the promoters of the company. I also think that there is a shortage of capital devoted to option writing despite the emergence of a few alternative investment funds in this area. Perhaps there are other less well understood barriers to implementing a diversified option writing strategy in India.

Posted at 1:41 pm IST on Fri, 2 Nov 2018         permanent link

Categories: derivatives

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