Co-Movements of Index Options and Futures Quotes
Dice Center Working Paper Series No. 2005-10
27 Pages Posted: 15 Apr 2005 Last revised: 8 Aug 2008
Date Written: June 1, 2008
Abstract
We report evidence that the co-movements of index options and index futures quotes differ sharply from perfect correlation in periods with option trades. In half-hour intervals with (without) option trades 25% (12%) of call option quote changes have either the opposite sign or are larger in magnitude than the corresponding index futures quote changes. We calibrate a stochastic volatility model that allows for trade and no-trade periods using real data and simulate the joint co-movements of index quotes and option quotes in this model. We show that for trade intervals the observed co-movements differ from the benchmark case established by our simulations approximately three times too often. We provide empirical evidence that market microstructure effects - specifically, stale quotes and aggressive quotes - explain the majority of the deviations from the benchmark. Our findings are relevant for techniques that use estimates of local co-movements as inputs to price or hedge options.
Keywords: Options, Frictions, Market Microstructure, Stale Quotes, Market and Limit Orders
JEL Classification: G13, G14, C33
Suggested Citation: Suggested Citation
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