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Mispricing of Index Options with Respect to Stochastic Dominance Bounds?

Martin Wallmeier

Critical Finance Review, 2021, vol. 10, issue 1, 21-55

Abstract: For one-month S&P 500 index options, Constantinides et al (2009) report widespread and substantial violations of stochastic dominance bounds. According to the subsequent study of Constantinides et al (2011), the violations can be exploited to generate abnormal trading profits. The reported mispricing, which is far more extreme than known from the pricing kernel puzzle, calls into question that option markets meet the most basic requirements of rational pricing. However, we find that index options on the S&P 500, EuroStoxx 50 and DAX are priced almost perfectly in line with stochastic dominance bounds when adjusting for (a) the general level of option prices, (b) conditional volatility and (c) put-call parity in order to determine the appropriate (dividend-adjusted) underlying index level. Our results indicate that index option markets might be much more efficient than previous literature suggests.

Keywords: Index options; Stochastic dominance; Volatility smile; Implied volatility (search for similar items in EconPapers)
JEL-codes: G11 G14 G24 (search for similar items in EconPapers)
Date: 2021
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