Option boundaries in index

options in India

By,
Rajeev Kumar (09FN088)
Rakesh Mathi (09FN089)
Contents
1. Introduction ..................................................................................................................................... 1
1.1 History – F&O Market in India............................................................................................... 1
1.2 Index options market in India ................................................................................................. 1
2. Literature review ............................................................................................................................. 3
3. Methodology ................................................................................................................................... 5
3.1 Price Calculation ..................................................................................................................... 5
3.2 Lower boundary condition for index options .......................................................................... 5
3.3 Data ......................................................................................................................................... 7
4. Future scope .................................................................................................................................... 7
5. References ....................................................................................................................................... 8
 1. Introduction

1.1 History – F&O Market in India

Derivatives trading commenced in India in June 2000 after SEBI granted the final
approval to this effect in May 2001. SEBI permitted the derivative segments of two stock
exchanges, NSE and BSE, and their clearing house/corporation to commence trading and
settlement in approved derivatives contracts. To begin with, SEBI approved trading in index
futures contracts based on S&P CNX Nifty and BSE–30(Sensex) index. This was followed
by approval for trading in options based on these two indexes and options on individual
securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in options on
individual securities commenced in July 2001. Futures contracts on individual stocks were
launched in November 2001. The derivatives trading on NSE commenced with S&P CNX
Nifty Index futures on June 12, 2000. The trading in index options commenced on June 4,
2001 and trading in options on individual securities commenced on July 2, 2001.

The index futures and options contract on NSE are based on S&P CNX Trading and
settlement in derivative contracts is done in accordance with the rules, byelaws, and
regulations of the respective exchanges and their clearing house/corporation duly approved
by SEBI and notified in the official gazette. Foreign Institutional Investors (FIIs) are
permitted to trade in all Exchange traded derivative products.

1.2 Index options market in India

BSE and NSE are offering 5 index options products each. All the products are
European contracts. Although there have been products trading of index options never took
off big in BSE. At present the open interest in Index options in BSE is 2 whereas the no of
contracts traded in this financial year in NSE are 166066320. Figure 1 shows the products
available at NSE.

Underlying Index Product code

S&P CNX Nifty NIFTY

S&P CNX Nifty MINIFTY

CNX IT CNXIT

BANK Nifty BANKNIFTY

Nifty Midcap 50 NFTYMCAP50

Figure 1 - Index option products in NSE

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 Figure 2 - Growth in derivative market in NSE

In the earlier years of the introduction of derivative trading in India, the investors
were trading more in futures than the options. According to figure 2, the data published by
NSE, stock futures were the most preferred product in NSE from 2002 to 2008. The share of
stock futures in F&O market is ranging from 50 – 64% over those 7 years. But after 2008 the
dynamics of F&O market are changed and Index options started taking off. Share of index
options, as shown in figure 3, in F&O market is more than 50% now. This can be attributed
to the below two factors

1) Regulatory efforts by government

In March 2008 budget, government had said the STT (Securities transaction tax)
will be levied only on the option premium instead of the contract value. This has
helped the investors to invest more on index options.

2) Recession effect on the risk appetite of investors

Options are less risky compared to that of futures. An investor will have the risk
of losing only the option premium and not the contract value in options whereas in
futures the risk will be on the total contract value. Recession had a great effect on
the risk appetite of the investors and made options more attractive to them than
futures.

As per the data released by NSE in June 2010, NIFTY is the 3rd highest traded index
option product in the world after the Korean Index (KOSPI 200 options) and SPDR S&P 500
ETF options. NSE could achieve this only because of the above factors.

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 60
50
40
30
20 No of contracts
10 Total Turnover
0
2004-05

2008-09
2000-01
2001-02
2002-03
2003-04

2005-06
2006-07

2009-10
2010-11
Figure 3 - Share of index options in F&O market of NSE

2. Literature review

In this section, we provide brief review of literature dealing with efficiency of the
option market. In light of testing options market efficiency, Black and Scholes (1972, 1973)
tests the options valuation model using estimates of variance returns on the common stock for
US market and finds model as an accurate estimate of the variance, where, the high variance
stocks causing the model to overprice options and under-price options on low variance
stocks. Their later study empirically test the option valuation formula by deriving a
theoretical valuation formula with an assumption that efficiently priced options will not
provide definite profits in the market. The test proved to be the better working of the option
pricing model and suggested its applications for all corporate liabilities such as common
stock, corporate bonds and warrants. After the proposition of option pricing model by Black
and Scholes, Dan Galai (1977), examines the efficiency of CBOE using their option pricing
model and find consistency of the model with the trading strategies based on two hedging
tests; ex post and ex ante. Specifically, this model performs well on ex post hedge returns
(where the hedges are based on the model's evaluations of prices vs. the market prices).
Similarly, Mittnik and Rieken, (2000), investigate for German DAX–options market by
simulating the trading strategies using ex-ante and ex-post tests, where the simulation tend to
be violated without showing any strong evidence on the market efficiency.

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 The study of Cavallo and Mammola (2000), investigate the efficiency of Italian
index option market through put–call parity conditions. Additionally, find the validity of
Black and Scholes option pricing model using volatility hedging strategies. The result of put–
call parity conditions seems to be a weak test for market efficiency. However, the test of
volatility hedging strategy does not provide any systematic abnormal returns, and are
consistent with the market efficiency.

There are few studies which examine the efficiency option markets internally and
with across markets through arbitrage pricing relationships using the box spread, call and put
spreads, and call and put convexity. This type of test is conducted by Ackert and Tian
(2000, 2001) on S&P 500 index options market for US. They find frequent mispricing in the
market and indicate that the market is inefficient because of arbitrage limitations. Their later
study in testing the efficiency of S&P 500 index options market and cross market effect of a
traded stock basket, Standard and Poor's Depository Receipts (SPDRs), on the link between
index and options markets finds the improvement of pricing efficiency within option market,
but does not support for enhancement of arbitrage across market by stock basket. Similar
tests for European market conducted by Capelle-Blancard and Chaudhury (2001) on CAC
40 index option for French market and Brunetti and Torricelli (2004) on MIB 30 index option
for Italian market. The former study verify the internal efficiency across S&P 500 index
options market and find violations in the market and coincides with brisk trading and exhibit
systematic patterns in contrast to US market. The later study verifies the cross market
efficiency with French market and finds a common pattern with the French market. The
overall result supports the efficiency of Italian market and shows the high level of
consistency between internal and cross market efficiency.

In India, the studies in this kind of subject are limited where the existing literature of
Varma (2002), examines the pricing efficiency of options market on NSE index options
using Breeden- Litzenberger formula on the basis of estimated implied volatility smiles and
finds the sever under-pricing of volatility. While his test of pricing efficiency using put-call
parity theorem finds the over- pricing of deep in the money call options and show
inconclusive evidence of violations of put- call parity. Misra and Sangeeta (2005) examine
existence of violation of put-call parity on the same NSE Nifty index options and exhibit the
put-call parity relationship violations in the market.

It has been found in the Indian market since price is not in line with the sound
principle of option pricing so a correct price-discovery mechanism is not prevalent in the
market (sanjay sehgal,2009).It is because option aren’t traded at efficient best delta hedging
capacity of the option is also quite low. In India even if the value of the option is calculated
by the weighted implied volatility measure the value obtained and the value at which it is
traded are found to be different( jayant varma ,2002); in the same analysis he used implied
volatility to prove that in the Indian context the put-call parity doesn’t hold. In case of Indian
market it has also been established that NSE Nifty derivatives markets tend to lead the

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underlying stock index. The slightly over time (sathya swaroop Debashish,2009).After
reading those literature it has become important to analyse and compare the Indian market
with developed country market and see what is the real issue behind the price-mismatch and
market efficiency. One of the major reasons that has been supported by various researcher is
that it is because there does exist restriction on the short-sale in the Indian market, so it
doesn’t allow traders to take advantage of the arbitrage opportunity that may arise if the
option are traded at less than their optimum value (Rakesh Gupta, 2010).

3. Methodology
3.1 Price Calculation

NSE uses the Black-Scholes method to calculate the theoretical price of the options contract.
Base price of an option contract is calculated by NSE as follows

For a new contract,

The base price of the contract will be the theoretical price of the options contract
arrived at based on Black-Scholes model of calculation of options premiums.

For subsequent trading days,

 If the contract is traded in the last half an hour, the closing price shall be the last
half an hour weighted average price.

 If the contract is not traded in the last half an hour, but traded during any time of
the day, then the closing price will be the last traded price (LTP) of the contract.

 If the contract is not traded for the day, the base price of the contract for the next
trading day shall be the theoretical price of the options contract arrived at based
on Black-Scholes model of calculation of options premiums.

Price Band:

Price band for the index options is contract specific. It is on the based on the
delta value of contract. Price band is computed and updated on a daily basis as per the delta
value of the contract. Orders placed at prices which are beyond the operating ranges would
reach the Exchange as a price freeze.

3.2 Lower boundary condition for index options

The LBC, first proposed by Merton and further extended by Galai assumes a major
role in assessing options market efficiency. To date, a number of research studies have been
carried out in different options markets using the LBC to assess the efficiency of the markets,

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including the first one by Galai. The LBC of option prices denotes the minimum price of the
option contract at a given point of time; its violation indicates arbitrage opportunities.
Therefore, the price for an option contract should necessarily be equal to or higher than that
suggested by the LBC. This is a necessary (although relatively weak) condition that needs to
be satisfied in order to uphold the no-arbitrage argument of option pricing to ensure the
correct pricing.

In the literature, the LBC has been defined for both the European options as well as
American options. Because we are analysing the S&P CNX Nifty Index options and these are
European (which can be exercised only at maturity) in nature, the condition defined for
European options constitutes the basis of the study.

The LBCs defined for the call and put options are given in equations (1) and (2) respectively;
these conditions need to be satisfied in an efficient market.

Ct  max{0, ( I t  ke r (T t ) )} ------(1)

Pt  max{ 0, (ke r (T t )  I t )} ------(2)

In the above equations, Ct is the market price of a call option at time t, Pt is the market price
of a put option at time t, It is the level of underlying index (S&P CNX Nifty) at time t, K is
the strike price of the option contract, T is the expiration time of the option at the time when
it was floated, r is the continuously compounded annual risk-free rate of return and (T-t) is
the time-to-maturity of the option at time t (measured in years).

Equations (1) and (2) describe the LBCs where the underlying asset is not expected to pay
any dividends during the life of the option. Because, in general, almost all the financial assets
pay dividends, equations (1) and (2) need to be modified by incorporating dividends. The
treatment of dividends in the test varies based on the assumption made about the payment of
dividends. Some of the studies treated it as a discrete payment and others as a continuous
yield. In this study, since S&P CNX Nifty Index (which includes 50 scrips) based options are
being analysed, it would be difficult to test the LBC, assuming discrete dividends.

Therefore, following Chance, it has been assumed that dividends are paid as continuously
compounded yield. The LBC equations for call and put options, assuming that the index is
paying continuously compounded annual dividend yield (d), are given in equations (3) and
(4) respectively.

 ( T  t )
Ct  max{0, (e I t  ke r (T t ) )} ----(3)
 ( T  t )
Pt  max{ 0, (ke r (T t )  e I t )} ----(4)

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 3.3 Data

The data to be considered for the analysis can be broadly classified into three categories,
namely, data related to option contracts, data related to the underlying asset (that is, the main
index of the NSE, formally known as the S&P CNX Nifty Index) and data on the risk-free
rate of return. The data on the options consist of daily closing prices of options, strike prices,
deal dates, maturity dates and number of contracts of call and put options respectively. In
order to minimise the bias associated with non synchronous trading, only liquid option
quotations (that is, contracts that have at least one contract traded) will be considered for the
analysis. The second data set pertains to the underlying asset, which includes the daily
closing value of S&P CNX Nifty Index and the dividend yield on it. The third data set
consists of monthly average yield on 91-day Treasury-bills. The data on T-bills have been
converted into a continuously compounded annual rate of return.

The data for these three categories will be collected between 4 June 2001 (the starting date
for index options in the Indian securities market) and 30 July 2010. The first and second data
sets will be collected from the website of NSE and CMIE (Centre for Monitoring Indian
Economy) database Prowess, and the third data set will be collected from the website of
Reserve Bank of India.

4. Future scope

Derivatives are considerably young in India. As explained earlier, Index option has become
most traded derivative instrument now. One in every 2 derivatives traded in Indian market is
an index option. Many earlier studies suggest that option pricing was not efficient in India till
2008. But after 2008 there has been a quantum leap in the number of market participants
trading the index options. Thus, it becomes imperative to establish that whether the
inefficient pricing is still prevalent. We would be making assessment on the number of
boundary violation on NIFTY and on CBOE to check the inefficient pricing. This would help
us establish a relationship between a developed market and a developing market on the basis
of the number and degree of the boundary violation. Second objective of our research would
be to learn and analyse difference between put option and call option boundary violation.
This would help in determining which of the two types of option are more price-efficient and
thus has less probability of sub-optimal pricing.

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 5. References

1. “An econometric analysis of the lead-lag relationship between India’s NSE Nifty and its
derivative contracts” by Sathya Swaroop Debasish, Journal of Risk Finance, 2009.
2. “Mispricing of Volatility in the Indian Index Options Market” by Jayanth R Varma, April 2002.
3. “S&P 500 Index option tests of Jarrow and Rudd approximate Option valuation formula” by
Charles J. Corrado, 1996.
4. “Short-sales Restrictions and Efficiency of Emerging Option Market: A Study of Indian Stock
Index Options” by Rakesh Gupta,2010
5. “Testing of pricing efficiency of the Indian index options market” by Sanjay Sehgal,
International Journal Business and Society ,2009
6. Ackert, L.F., and Tian, Y.S. (1998). The introduction of Toronto index participation units and
Arbitrage opportunities in the Toronto 35 index options markets. Journal of Derivatives,
7. Ackert, L.F., and Tian, Y.S. (2000). Evidence on the efficiency of index options markets,
Federal Reserve Bank of Atlanta Economic Review, First Quarter.
8. Black, F., and Scholes, M. (1972). The valuation of option contracts and a test of market
efficiency. Journal of Finance, 27, 399-418.
9. Brunetti. M., and Torricelli, C. (2003). The put-call parity in the index options markets: further
results for the Italian mib30 options market. Materiali di Discussione, Dipartimento di
Economia Politica, Università di Modena e Reggio Emilia, N. 436.

10. Capelle-Blancard G., and Chaudhury, M. (2001). Efficiency tests of the French index (CAC
40) Options market. Working paper, McGill Finance Research Center, SSRN
11. Cavallo, L., and Mammola, P. (2000). Empirical tests of efficiency of the Italian index options
market.