Identifying underpricing in index options

Abstract

This study analyses the occurrence and extent of underpricing of index options on the National Stock Exchange (NSE) of India. The study uses discriminant analysis to explain the incidence of underpricing, and regression analysis to explain the extent of underpricing. Further, the study proposes three sets of models to explain underpricing of options. The first set of models considers only the impact of moneyness on underpricing. The second set of models considers the impact of both moneyness and time to expiration on underpricing. The third set of models considers the impact of moneyness, time to expiration, and changes in returns and volatility of the underlying asset on underpricing.

The results of the study would enable speculators to identify arbitrage opportunities by predicting the occurrence and magnitude of underpricing in index options, vis-à-vis trading costs, in terms of moneyness, time to expiration, returns of the underlying index, and the volatility of the underlying index. The results also identify the inefficiencies of options in the price discovery mechanism, which the exchange can try to rectify by provision of sufficient market demand and liquidity.