Options pricing and short‐selling in the underlying: Evidence from India

• Author: Alok Dixit,Shivam Singh,Vipul
• Published date: 01 October 2019
• Date: 01 October 2019
• DOI: http://doi.org/10.1002/fut.22040

J Futures Markets. 2019;39:1250–1268.wileyonlinelibrary.com/journal/fut1250

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© 2019 Wiley Periodicals, Inc.

Received: 14 July 2017

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Revised: 6 June 2019

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Accepted: 8 June 2019

DOI: 10.1002/fut.22040

RESEARCH ARTICLE

Options pricing and short‐selling in the underlying:

Evidence from India

Alok Dixit

1

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Vipul

1

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Shivam Singh

2

1

Finance and Accounting, Indian Institute

of Management Lucknow, Lucknow,

Uttar Pradesh, India

2

Credit Suisse, Mumbai, Maharastra,

India

Correspondence

Vipul, Finance and Accounting, Indian

Institute of Management Lucknow, #215,

Faculty Block, IIM Campus, IIM Road,

Lucknow, Uttar Pradesh 226013, India.

Email: vipul@iiml.ac.in

Abstract

This study provides new insights into certain recent developments in derivatives

trading in India. Specifically, it examines the implications of introduction of

short‐selling for pricing efficiency of the Nifty 50 index derivative contracts of

National Stock Exchange of India. The empirical results suggest that the

introduction of short‐selling, supported by a well‐functioning security lending

and borrowing market, has significantly reduced the overpricing of Nifty 50

index put options. Moreover, the introduction of this short‐selling mechanism

has lessened the underpricing of Nifty 50 index futures.

KEYWORDS

index futures, index options, Indian derivatives market, mispricing, put–call–futures parity, short‐

selling

JEL CLASSIFICATION

G13; G14

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INTRODUCTION

Short‐selling refers to selling the stocks that one does not own at the time of trade. This facility is an important

mechanism to restore equilibrium in financial markets by facilitating arbitrage. The security to be shorted is usually

borrowed from a market player, and is sold with an expectation that its price will drop. It can be executed in two forms:

naked short‐selling and covered short‐selling. Many market regulators, including the Securities Exchanges Board of

India (SEBI) in India, prohibit naked short‐selling to curb the speculative activities that may lead to a downward price

spiral. Therefore, short‐selling would refer to covered short‐selling for the rest of the study.

As outlined by the International Organization of Securities Commissions, short‐selling smoothens the functioning of

financial markets by increasing liquidity, facilitating price discovery, mitigating market bubbles, enabling spread

trading, providing opportunities for risk management activities, and limiting upward market manipulations. A market

without short‐selling facility may be subject to certain inefficiencies. Stock lending transactions usually take place in the

OTC market among large institutional investors worldwide. However, in emerging markets with low institutional

ownership, regulators often consider operating a centralized stock lending mechanism to provide liquidity (Huszár &

Porras Prado, 2019). Several studies have addressed this issue. Most of such studies remained focused on the equity

market, and examined the effect of short‐selling restrictions on the pricing efficiency of equity markets (Beber &

Pagano, 2013; Boehmer & Wu, 2013; Boehmer, Jones, & Zhang, 2013; Bris, Goetzmann, & Zhu, 2007; Chang, Cheng, &

Yu, 2007; D’Avolio, 2002; Diether, Lee, & Werner, 2009; Figlewski, 1981; Geczy, Musto, & Reed, 2002;

Harrison & Kreps, 1978; Jones & Lamont, 2002; Lintner, 1969; Miller, 1977; Mitchell, Pulvino, & Stafford, 2002;

Ofek & Richardson, 2003; Saffi & Sigurdsson, 2010, among others). The restrictions on short‐selling examined in these

studies were mostly a response to the financial crisis of 2008.

A few studies have also examined the effect of short‐selling on derivatives. For examining the effect of restrictions on

short‐selling, these studies have used a range of indicators, like put–call parity violations, changes in bid–ask spreads,

volatility of stocks, and traded volume of options. Ofek, Richardson, and Whitelaw (2004) found that the put–call parity

violations occurred more frequently because of restrictions on short‐selling. The violations appeared to persist, even

after accounting for the transaction costs (TC). Cakici, Goswami, and Tan (2018) found that, for the US market, the

option spreads and the implied volatility increased during the short‐selling restrictions of 2008, for the stocks with

restricted short‐selling. The violations for the American‐type options on such stocks recorded a significant increase

during the restriction period. Similarly, Grundy, Lim, and Verwijmeren (2012), and Battalio and Schultz (2011)

observed that the stocks with constrained short‐selling had significantly higher bid–ask spreads during the restriction

period. Moreover, when they replicated a stock synthetically with options, the price of stocks with short‐selling

restrictions appeared to be significantly lower than their actual market price. They attributed this result to the increased

hedging costs for such stocks. Not many studies have assessed the effect of short‐sale restrictions on the efficiency of

options market. The only known study in the Indian context (Gupta & Jithendranathan, 2010) provided some

incomplete evidence. First, the findings of the study are subject to nonsynchronous error, as it uses the closing data.

Second, it reported frequent violations of the parity condition in the absence of short‐selling facility, but did not cover

the period when short‐selling was in place. SEBI introduced short‐selling facility in India with effect from April 2008

through the exchange‐based security lending and borrowing (SLB) mechanism.

This article examines the impact of introduction of short‐selling on the Nifty 50 index options and futures. The study

contributes to the literature in several ways. First, this is one of the first few studies to examine the effect of introduction

of short‐selling, on the pricing efficiency of Nifty 50 index options. The Nifty 50 index represents a volume‐weighted

index of top 50 most actively traded companies in the Indian equity market. This index is important not only for the

domestic investors, but also for the international investors, who desire to have Indian equity exposure. The Singapore

Exchange Limited (SGX) started trading of Nifty 50 index futures (SGX Nifty 50 futures) in the year 2000 itself, when

the NSE introduced the index futures on Nifty 50 in the Indian market (Appendix A). In recent years, the SGX Nifty 50

futures have attracted the attention of international investors. The study provides an insight into the behavior of a

market that enters the short‐selling regime, facilitated by an exchange‐based SLB mechanism.

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Earlier studies have

examined the role of short‐selling constraints on the mispricing of individual stock options, where the individual stock

futures are generally not available (or not liquid). In contrast, both the index and single stock futures (SSFs) trade

actively in the Indian derivatives market. The study, therefore, is expected to offer a novel contribution to the literature,

on the role of short‐selling facility in the underlying stocks. Second, this study also examines the changes in the

efficiency of Nifty 50 futures pricing, following the introduction of short‐selling. Third, it is one of the pioneering

studies on a major emerging market like India. National Stock Exchange of India (NSE) was ranked second among the

derivatives exchanges of the world, based on the volume of contracts traded during the calendar year 2015.

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Some more

details on the Indian derivatives market and its development are provided in Appendix A. Fourth, it uses a time‐

stamped intraday data set, obviating the nonsynchronous error. The study, based on an examination of 1,647,732

triplets of calls, puts, and futures, indicates asymmetric violations of put–call–futures parity (PCFP). There is evidence

that the introduction of short‐selling facility significantly reduced the relative overpricing of Nifty 50 index put options,

and the underpricing of Nifty 50 index futures. The results further suggest that this reduction took time to become

effective, as the short‐selling mechanism became entrenched in the market slowly.

The remaining article is organized as follows. Section 2 introduces the background of short‐selling mechanism in the

Indian market. The details of the methodology and the data used in the study are provided in Sections 3 and 4. Section 5

presents and discusses the results, and Section 6 concludes the article.

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SHORT‐SELLING IN THE INDIAN MARKET

Short‐selling was indirectly allowed in the Indian market through “Badla”system, which was a carry‐forward system

devised on the Bombay Stock Exchange. This mechanism was discontinued in 2001, with the introduction of equity

futures in the Indian derivatives market. After that, for a long time, there was no formal mechanism for the Indian

1

In India, the short‐selling of stocks was permitted through stock exchanges (e.g., NSE) with an organized SLB facility from April 2008. Before that, the short‐selling could be done through the informal

market route, which is an expensive and inconvenient option, particularly for the retail investors.

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Source: Futures Industry Association; rankings are based on the number of contracts traded or cleared between January 2015 and December 2015.

DIXIT ET AL.

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