Are Options on Index Futures Profitable for Risk Averse Investors? Empirical Evidence

Constantinides, George M., Jackwerth, Jens Carsten, Czerwonko, Michal and Perrakis, Stylianos (2008): Are Options on Index Futures Profitable for Risk Averse Investors? Empirical Evidence. Unpublished.

Abstract

American call and put options on the S&P 500 index futures that violate the stochastic dominance bounds of Constantinides and Perrakis (2007) over 1983-2006 are identified as potentially profitable investment opportunities. Call bid prices more frequently violate their upper bound than put bid prices do, while evidence of underpriced calls and puts over this period is scant. In out-of-sample tests, the inclusion of short positions in such overpriced calls, puts, and, particularly, straddles in the market portfolio is shown to increase the expected utility of any risk averse investor and also increase the Sharpe ratio, net of transaction costs and bid-ask spreads. The results are strongly supportive of mispricing. (JEL G11, G13, G14)

• Item Type: MPRA Paper
• Language: English
• Keywords: Risk Averse, Option, Index Futures
• Subjects: G - Financial Economics > G1 - General Financial Markets > G14 - Information and Market Efficiency; Event Studies; G - Financial Economics > G1 - General Financial Markets > G11 - Portfolio Choice; Investment Decisions; G - Financial Economics > G1 - General Financial Markets > G13 - Contingent Pricing; Futures Pricing

References

Black, F. and M. S. Scholes, 1973, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy 81, 637-654.

Bogle, J. C., 2005, “The Mutual Fund Industry 60 Years Later: For Better or Worse?” Financial Analyst Journal 61, 15-24.

Cerny, A., 2004, “Introduction to Fast Fourier Transform in Finance,” Journal of Derivatives 12, 73-88.

Constantinides, G. M., 1986, “Capital Market Equilibrium with Transaction Costs,” Journal of Political Economy 94, 842-862.

Constantinides, G. M., 2002, “Rational Asset Prices,” Journal of Finance 57, 1567-1591.

Constantinides, G. M., J. C. Jackwerth, and S. Perrakis, 2008, “Mispricing of S&P 500 Index Options,” Review of Financial Studies, forthcoming.

Constantinides, G. M. and S. Perrakis, 2002, “Stochastic Dominance Bounds on Derivatives Prices in a Multiperiod Economy with Proportional Transaction Costs,” Journal of Economic Dynamics and Control 26, 1323-1352.

Constantinides, G. M. and S. Perrakis, 2007, “Stochastic Dominance Bounds on American Option Prices in Markets with Frictions,” Review of Finance 11, 71-115.

Coval J. D. and T. Shumway, 2001, “Expected Option Returns,” Journal of Finance 56, 983-1009.

Davidson, R., 2007, “Testing for Restricted Stochastic Dominance: Some Further Results,” Working Paper, McGill University.

Davidson, R. and J.-Y. Duclos, 2000, “Statistical Inference for Stochastic Dominance and for the Measurement of Poverty and Inequality,” Econometrica 68, 1435-1464.

Davidson, R. and J.-Y. Duclos, 2006, “Testing for Restricted Stochastic Dominance,” Working Paper, McGill University.

Dimson, E., P. Marsh, and M. Staunton, 2006, “The Worldwide Equity Premium: A Smaller Puzzle,” Working paper, London Business School.

Fama, E. F., and K. R. French, 2002, “The Equity Premium,” Journal of Finance 57, 637- 660.

Härdle, W., 1990, Applied Nonparametric Regression, Cambridge Univ. Press.

Hull, J. C., 2006, Options, Futures, and Other Derivatives, Prentice Hall.

Jackwerth, J. C., 2000, “Recovering Risk Aversion from Option Prices and Realized Returns,” Review of Financial Studies 13, 433-451.

Jackwerth, J. C., 2004, “Option-Implied Risk-Neutral Distributions and Risk Aversion,” ISBN 0-943205-66-2, Research Foundation of AIMR, Charlottesville, USA.

Jackwerth, J. C. and M. Rubinstein, 1996, “Recovering Probability Distributions from Option Prices,” Journal of Finance 51, 1611-1631.

Jobson J. D. and B. M. Korkie, 1981, “Performance Hypothesis Testing with the Sharpe and Treynor Measures,” Journal of Finance 4, 889-908.

McDonald, R. L., 2006, Derivatives Markets, Addison-Wesley. Memmel, C., 2003, “Performance Hypothesis Testing with the Sharpe Ratio,” Finance Letters 1, 21-23.

Merton, R. C., 1973, “Theory of Rational Option Pricing,” Bell Journal of Economics and Management Science 4, 141-183.

Perrakis, S. and M. Czerwonko, 2006, “Transaction Costs and Stochastic Dominance Efficiency in the Index Futures Options Market,” Working paper, Concordia University.

Rubinstein, M., 1994, “Implied Binomial Trees,” Journal of Finance 49, 771-818.

Stoline, M. R. and H. K. Ury, 1979, “Tables of the Studentized Maximum Modulus Distribution and an Application to Multiple Comparisons among Means,” Technometrics 21, 87-93.

Yu, K. and M. C. Jones, 1998, “Local Linear Quantile Regression,” Journal of the American Statistical Association 93, 228-237.