Academic journal article IUP Journal of Applied Finance

The Market Microstructure Linkages of Emerging Options Market and Stock Market

Academic journal article IUP Journal of Applied Finance

The Market Microstructure Linkages of Emerging Options Market and Stock Market

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Introduction

A frictionless market is characterized by information flow that follows a Brownian motion (Kyle, 1985). When markets are efficient the price discovery happens after the information arrival, and since nobody can predict the information arrival, market prices would be unpredictable. According to the notion of frictionless markets, the options markets are redundant because they convey no additional information to underlying market (hereafter stock markets). Therefore, the theory of option pricing portends that stock prices have information for option prices and not vice versa. However, the frictions like information asymmetry would mean that the informed could either trade their information in options market or in stock markets. In such a situation, the options market would send cues for the stock market. Several studies have brought out the significance of microstructure linkages of options markets and stock markets with highly conflicting evidence.

According to Vijh (1990), the stock prices lead the options prices suggesting that it is the stock prices that have information and not the option prices. Typically, the bid-ask spreads in the options markets are higher and if the benefit from information is less than the spread then the informed will rather trade the information in stock market. Also, Stephen and Whaley (1990) find evidence to corroborate the results of Vijh (1990). Contrary to this, some of the recent studies report results which suggest that the options markets do convey information to the stock markets (Easley et al., 1998). Studies by Chakravarty et al. (2004) and Pan and Poteshman (2006) have come up with unambiguous results of informed trading in options markets.

The motivation for this paper is to study this conflict in the Indian context. Some of the earlier studies in India report market inefficiency and the presence of persisting arbitrage opportunities (Vipul, 2008). Also, Nidhi and Susan (2011) study the microstructure data of futures market and stock market and find that futures prices lead the stock prices discovery because futures are more liquid. However, the present study used options dataset which is incidentally not as liquid as the futures. We also report that the options market leads the stock market. This finding supplements the earlier studies but finds evidence for options markets to be venues for private information which is a unique result.

This study employs the methods of Hasbrouck (1991), Easley et al. (1998) and Chan et al. (2002) and finds unambiguously that the informed do trade in options market and options markets reveal private information to stock markets. The study has implications for options traders to help understand the behavior of market participants. Likewise from a regulation perspective, since the presence of private information trading is not good for market efficiency, the regulators may wish to understand the private information more closely and find if the private information so obtained is tantamount to insider trading.

The following sections cover a review of Indian derivatives market, the review of relevant literature, empirical specifications and the results of the study. The results are followed by concluding remarks with cues for further research.

Indian Derivatives Markets

Indian regulation on derivative instruments witnessed shifts. These shifts included banning derivatives to restrained introduction of trading in these instruments. From 1991 onwards, with economic liberalization, Indian economy witnessed a marked shift in the government policy in this regard. Two committees were set up by Securities and Exchange Board of India (SEBI), which is the apex regulator of the financial markets, one headed by Gupta (1996) and the other by Varma (1998). The first committee dwelled on the need for and the way derivative instruments could be introduced in India, which covered broad preconditions prior to introducing derivatives. …

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