Price Discovery under Different Market Conditions and Factors: A Study on Indian Market

Rajesh Pathak IBS, Hyderabad Deepak Agrawal DenuoSource Knowledge Center, Hyderabad

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Theoretical Prediction: Derivative Markets are Venue for Information Based

Trading.

Black (1975), Empirical Question:

To what extent derivatives market affect price discovery on the spot market? Lead Lag Approach Informatio n Share Approach

Relationship between spot and derivatives prices

Manaster and Rendleman (options, 1982)
+

Information content in trading activity of derivatives market

Bhattacharya (options, 1987) + Stephen and Whaley (Options, 1990) + Chan et. al. (options, 1993) + Jong et. al. (Futures and options, 1998) + Ansi (2009) Anthony (options, 1988) + Easley et. al. (options,1998) + Bhuyan et. al. (options, 2005) + Schlag and Stoll (Futures and options, 2005) + Sarwar G. ( Options, 2005) +

Stephen and Whaley (options, 1990) + Chan, Chung and Fong (Options, 2002)

Hasbrouck (1995) + Chakravarty et. al. (options, 2004) + Chan, Chang and Lung (Options, 2010)

Kawaller et. al. (Futures, 1987)

+

Chan (Futures, 1992)

+

Chen et al . (options 2005)

+

Options Trading activity is not informative Important informational role

Bhatia (Futures, 2007)

+

Chan, Chang and Lung (options markets Derivative2009) lead

Kumar S.S.S. (2008) conflicting or Inconclusive Evidence that informed traders use Results derivatives market

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Introduction

This study is an attempt to find out whether informed traders prefer derivatives (options) market and if yes, to what extent the trading activity from this market affects the price of underlying We account for various factor and market conditions e.g. bull vs. bear phase, moneyness, expiration week effect, which may affect the choice of a trader to place his trade and subsequently can result the aberration in price discovery process. We follow option trading value ratio model of Chen, Lung and Tay (2004) to examine the relationship between options and underlying market.
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Analytical Framework

Let us say that for a trader at time 0, the cash outflow for buying a call or put option will be as follows For call option: Qc * Pc and for put option Qp * Pp

Where Qc (Qp) are call(put) trading volumes and Pc (Pp) are call (put) premiums. At expiry T, the intrinsic value of these options will be Qc* (Su Xc) and Qp* (Xp Sd) respectively, where S represents underlyings price and X represents stike price. Subscripts c and p differentiate call and put options, whereas u and d indicate upward and downward movements of prices with probabilities u and d
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With his or her expected utility and limited wealth W0, the objective and constraint function will be as follows Maximize: u U (Qc* (Su Xc)) + d U (Qp* (Xp Sd)) Subject to: Qc * Pc + Qp * Pp = W0 Where U is the log utility function.

The Lagrange representation of this optimization problem will be L = u log {U (Qc* (Su Xc))} + d log {U (Qp* (Xp Sd))} (Qc * Pc + Qp * Pp - W0) Where is the Lagrange multiplier Solution of the first order condition of equation (C) w.r.t to Qc and Qp suggests that market participant can infer the relative magnitude of unobservable probabilities of price changes by6/13/12 observing the ratio of options trading values hereafter VR.

Data and Methodology

We employ data of four years from 01st January 2006 to 31st December 2009. Daily data has been collected from NSE website for Nifty index and its options. We also categorized them based on moneyness (Inthe-money, At-the-money and Out- of- the- money hereafter ITM, ATM and OTM), market cycle (Bull, Bear and recovery phase), moneyness under different cycles and, expiry and ex expiry We defined ITM, ATM and OTM contracts following Chen et al and Chan et al. ITM/OTM call options are options with strike price ranging from 80/105 to 95/120 percent of price in the spot market and ITM/OTM put options are options with strike price ranging from6/13/12 105/80 to 120/95 percent of underlyings price. ATM options are options with

To identify the cycles we plot daily index value against time and then based on the graph (figure 1) we segregated it into three periods namely bull phase (January 2006-December 2007), bear phase (January 2008- December 2008) and recovery phase (January 2009 to December 2009).

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Regression Model:
Rt = + VRt + t Here Rt is daily index returns and VRt is daily option value ratio . and t are the intercept and the error term respectively.
Entire All obs. t ( ) F (%) 989 0.124 3.93 15.45 1.5 ATM 988 0.3 9.87 97.53 9 ITM 865 0.087 2.57 6.63 0.8 OTM 901 -0.21 -6.44 41.56 4.4 All 500 0.129 2.89 8.36 1.7 ATM 500 0.156 3.512 12.33 2.4 Bull ITM 385 0.157 3.1 9.61 2.5 OTM 424 -0.25 -5.3 28.18 6.3 180 0.188 2.54 6.49 3 Expiry

Bear All obs. t ( ) F (%) 247 0.601 11.75 108.14 36 ATM 246 0.686 14.7 216.18 47 ITM 241 0.176 2.75 7.56 3.1 OTM 241 -0.185 -2.9 8.42 All 244 0.422 7.21 52.1 17.4 ATM 244 0.53 9.69 93.92 28

Recovery ITM 243 0.283 4.56 20.88 8 OTM 243 -0.343 -5.66 32.47 11.9

Ex Expiry

811 0.584 20.45 418 34.1

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To examine the place of information based trading we studied the lead lag relationship between index returns and VR for entire period, sub periods, and condition based samples We estimate the coefficients with the following model:

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VAR Results (entire period)

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VAR Results (Bull Phase)

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VAR Results(Bear Phase)

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VAR Results(Recovery Phase)

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VAR Results(expiry and ex expiry)

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Findings and Future Scope

Results support the theoretical framework of Chen et al (2005), that the stock returns are related to call put trading value ratios. Results of OTM options show feedback relationship suggesting traders preference for OTM options and also consistent with liquidity and leverage hypothesis. Other factors are not found influential. Results are subject to market wide information as index data is employed. Study can be extended using stocks data and also testing for industry effect to find if the relationship changes in case of marketwide information and stock 6/13/12 specific information.