Indian equity options: Smile, risk premiums, and efficiency

• DOI: http://doi.org/10.1002/fut.21971
• Date: 01 February 2019
• Published date: 01 February 2019

Received: 11 September 2018

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Accepted: 15 September 2018

DOI: 10.1002/fut.21971

RESEARCH ARTICLE

Indian equity options: Smile, risk premiums, and efficiency

Sonali Jain

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Jayanth R. Varma

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Sobhesh Kumar Agarwalla

Finance and Accounting Area, Indian

Institute of Management Ahmedabad,

Ahmedabad, India

Correspondence

Sonali Jain, Finance and Accounting

Area, Indian Institute of Management

Ahmedabad, Finance and Accounting

Area, Room 2902, Vastrapur, Ahmedabad

380015, Gujarat, India.

Email: sonalij@iima.ac.in

Abstract

We study the pricing of equity options in India which is one of the world’s

largest options markets. Our findings are supportive of market efficiency: A

parsimonious smile‐adjusted Black model fits option prices well, and the

implied volatility (IV) has incremental predictive power for future volatility.

However, the risk premium embedded in IV for Single Stock Options appears to

be higher than in other markets. The study suggests that even a very liquid

market with substantial participation of global institutional investors can have

structural features that lead to systematic departures from the behavior of a

fully rational market while being “microefficient.”

KEYWORDS

Indian equity, options market efficiency, risk premiums, volatility smile

JEL CLASSIFICATION

G11, G12, G14

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INTRODUCTION

We examine the pricing of Indian Equity Options market, which in 2017 was the world’s largest

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index options market

and Asia’s largest Single Stock Options (SSO) market.

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Indian equity derivatives market has many unique features that

provide a good setting to investigate the pricing efficiency of the options market at both micro and macro levels. Apart

from the large size and liquidity, the unfragmented market structure is expected to result in more efficient pricing of

derivatives. In India, all derivatives segments—index options, SSOs, index futures, and Single Stock Futures (SSFs)—

trade on the same exchange as the spot, potentially removing any noise arising from fragmented markets. The

availability and high liquidity of all these four classes of derivative contracts could make the markets more complete

and hence more efficient. In contrast, there are several factors that could differentiate Indian equity options markets

from those in other countries and could also make them potentially less efficient. First, Indian regulations

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and market

structure allow greater participation of noise traders in option‐writing than in other countries.

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Second, India has a very

liquid SSF market along with a highly liquid equity options market. This may channel leverage‐hungry informed

speculators into its highly liquid SSF markets, unlike most developed markets like Unites States. Third, illiquid strike

options are suspected to be used for tax manipulation in India. The literature on Indian derivative market is scant, and

this study is perhaps the first study that comprehensively examines the pricing efficiency of SSOs and (Nifty) index

option contracts at both micro and macro levels.

J Futures Markets. 2019;39:150–163.wileyonlinelibrary.com/journal/fut150

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© 2018 Wiley Periodicals, Inc.

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World Federation of Exchanges, Annual Statistics Guide, 2017.

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The equity derivatives turnover on NSE was about INR 648 trillion in 2015–2016 (SEBI Handbook of Statistics, 2016). The growth in the notional turnover of equity derivatives markets vis‐à‐vis the

equity cash segment is one of the highest in the world at 15.54 in 2016 (Discussion Paper on Growth and Development of Equity Derivatives Market in India, SEBI, 2017).

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For example, the Indian regulations do not allow mutual funds to write derivative contracts (SEBI Circular Cir/IMD/DF/11/2010).

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Discussion Paper on Growth and Development of Equity Derivatives Market in India, SEBI, 2017 (Chart 2).