IMPLIED INDEX AND OPTION PRICING ERRORS: EVIDENCE FROM THE TAIWAN OPTION MARKET

Ching-Ping Wang, Hung-Hsi Huang and Chien-Chia Hung

The International Journal of Business and Finance Research, 2011, vol. 5, issue 2, 115-125

Abstract: This study examines both restricted and unrestricted Black-Sholes models, according to Longstaff (1995). Using the Taiwan index options for each day from January 2005 to December 2008, the unrestricted model simultaneously solves the implied index value and implied volatility whereas the restricted model only solves the implied volatility. Next, this study compares the pricing performance of restricted and unrestricted Black-Scholes models. The empirical results show he implied index value is almost higher than the actual index value. Moneyness has a significant negative impact on the index pricing error for calls but negative impact for puts. Open interest has a significantly negative impact on the index pricing error for calls. Volatility for calls has no significant effect on the index pricing error. The path-dependent effect on index pricing error increases with index returns. The unrestricted model has significantly less option pricing bias for calls than the restricted model. The option pricing error for calls in the restricted model has much larger negative bias near the middle maturity. The R-square in the restricted model is always much larger than the unrestricted model for both calls and puts. Finally, the option pricing errors are significantly affected by moneyness and time to expiration for all cases; this fact is consistent with Longstaff (1995). Additionally, based on the criterion of adjusted R-square, this study investigated the optimal explanatory variables of index pricing error.

Keywords: Index pricing error; option pricing error; Black-Scholes; implied volatility; implied index (search for similar items in EconPapers)
JEL-codes: G12 G13 G14 (search for similar items in EconPapers)
Date: 2011
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