The Volatility Spillover Effect between Index Options and their Underlying Markets: Evidence from the US, the UK, and Taiwan

• Published date: 01 October 2017
• DOI: http://doi.org/10.1111/ajfs.12185
• Date: 01 October 2017
• Author: Ming‐Chun Wang,Chia‐Ying Chan,Christian Peretti,Hong‐Min Chen

The Volatility Spillover Effect between Index

Options and their Underlying Markets:

Evidence from the US, the UK, and Taiwan*

Chia-Ying Chan

Discipline of Finance, College of Management, Yuan Ze University, Taiwan

Christian de Peretti

Universite

´de Lyon, Universite

´Claude Bernard Lyon 1, Laboratoire de Sciences Actuarielle et Financi

ere

(EA2429), France

Ming-Chun Wang**

Department of Money and Banking, National Kaohsiung First University of Science and Technology, Taiwan

Hong-Min Chen

Discipline of Finance, College of Management, Yuan Ze University, Taiwan

Received 25 September 2015; Accepted 10 April 2017

Abstract

This study examines the volatility spillover effect among five index options and their underly-

ing markets. Results show that the bidirectional volatility spillover effect and the cross-market

leverage effect exist between index options and their underlying markets. Our findings con-

firm that the volatility spillover effect is generally outweighed by shocks in the underlying

market, and that the options implied price volatility is provoked by the information shock

occurring in both the cash and options markets to a higher degree. Through the volatility

impulse response function, this study shows that the options implied prices are more sensi-

tive to innovations in both markets.

Keywords Volatility spillover; Leverage effect; Bivariate GARCH-BEKK; Bivariate GARCH-

DCC; Impulse response function

JEL Classification: G1, G15

*Chia-Ying Chan acknowledges funding support from the Ministry of Science and Technol-

ogy, R.O.C., 105-2410-H-155-016.

**Corresponding author: Ming-Chun Wang, National Kaohsiung First University of Science

and Technology, Taiwan. No. 1, University Rd, Yanchao Dist., Kaohsiung City 824, Taiwan.

Tel: +886-7601-1000 ext. 3128, Fax: +886-7601-1039, email: gregory@nkfust.edu.tw.

Asia-Pacific Journal of Financial Studies (2017) 46, 700–733 doi:10.1111/ajfs.12185

700 ©2017 Korean Securities Association

1. Introduction

How asset volatility exhibits spillover and contagion effects across various markets is a

crucial issue in finance, especially with the integration of global capital markets.

Researchers usually examine volatility spillover among national equity markets (e.g.,

Hamao et al., 1990; Booth et al., 1997). Studies considering options markets are scarce.

1

The majority of studies examining mechanisms of information transmission

between options and their underlying markets test the lead–lag relationship at the

initial moment of price difference or when information is shared among co-inte-

grated markets.

2

The interaction among price volatilities, especially in the spillover

effect or the transmission between options and their underlying assets, remains

unclear. Yet, the effect of the volatility transmission is more important than the

price causality between two financial assets, as it characterizes the contingent effect

between two financial instruments which are related to the same underlying facto rs.

Given the foregoing, we are motivated to examine the volatility spillover effect

between index options and their underlying cash markets.

Our study contributes to the literature in four ways. First, to date, the volatility

spillover effect between options and underlying markets has not been investigated in

depth. Previous studies either explore the effect between equity markets only or focus

on a single capital market. We develop a general conclusion on the volatility spillover

effect between the underlying market and their options derivatives through analysis of

markets with different features. Thus, in this paper, index options from several desig-

nated markets are analyzed. Second, this paper applies data based on the post financial

crisis period (2011–2015) when the role of options contracts as vehicles for hedging,

speculation, or arbitrage by institutional and individual investors becomes increas-

ingly important. Third, our decision to first derive the implied share price from the

options market prices and then conduct our investigation using the bivariate

GARCH-BEKK model and GARCH-DCC model with leverage effects confirms that

the leverage effect also exists in the volatility spillover estimation. When we further

control for the turnover rate and market value of the underlying market in the mean

equation estimation, the results remain robust. Though literature on the contagion

effects between different equity markets is abundant, this study is the first to show the

existence of a volatility spillover effect and a cross-market leverage effect in the process

of volatility transmission between index options and their underlying markets. The

innovations in the underlying market as well as in the derivative demonstrate

relatively higher cross-market predictive power for the options markets. This study

1

For volatility spillover between options and their underlying shares, German index options

are studied in Booth and So (2003), US stock options are studied in Hatch (2003), and Hong

Kong index options are studied in So and Tse (2004).

2

For lead–lag relationships between stock options and cash markets, see Manaster and

Rendleman (1982), Chan et al. (1991), and Diltz and Kim (1996). For lead–lag relationships

between index options and cash markets, see Stoll and Whaley (1990), Do Jong and Donders

(1998), and Chiang and Fong (2001).

©2017 Korean Securities Association 701

The Volatility Spillover Effect between Index Options and their Underlying Markets

further investigates spillover effect during a crisis period by analyzing the 2009–2011

Euro crisis, finding that spillover effects are even more pronounced during a crisis.

Finally, through the investigation of the return volatility impulse response function,

we also observe that the options implied price return volatility is more sensitive to

innovation in both the cash and options markets.

The remaining sections are organized as follows. Section 2 reviews the literatur e

on our research issue and presents our hypotheses. Section 3 outlines the data and

methodology. Section 4 illustrates the empirical findings and analyses. Conclusions

are offered in Section 5.

2. Literature Review and Hypotheses

The volatility spillover effect states that volatility of asset prices in one market can

be explained or predicted by innovations in other markets. Thus, the price volatility

of markets is interdependent.

3

Research has investigated the lead–lag relation

between the cash markets and their derivatives across different capital markets. Stoll

and Whaley (1990) confirm S&P 500 index futures lead the underlying cash market

by about five minutes. Do Jong and Donders (1998) apply data on the AEX stock

index, index futures, and index options to examine the lead and lag relation among

the three financial instruments. They find that futures contracts lead both the

underlying and the options markets, and suggest that the futures market is more

informative. Moreover, the lead–lag relation between the underlying market and

the options market is reciprocal. Chiang and Fong (2001) study the lead–lag rela-

tion between the Hong Kong HIS index, index futures, and index options. They

find that the futures markets are favored by traders and that they lead the cash

market. In addition, the cash market leads the options market. Zhong et al. (200 4)

investigate the lead–lag relationship between IPC index futures contracts and the

Mexican spot index. They find the introduction of the index futures induces volatil-

ity in the spot market, but at the same time, performs price discovery functions.

Several researchers have investigated whether the return volatility is affected by

innovations in other markets. Chan et al. (1991) observe bilateral spillover between

index futures and cash index markets in the US, while Tse (1999) finds a bilateral and

asymmetric spillover effect in the US. Moreover, the effect increases in intensity for

futures to cash markets. Booth et al. (1999) propo se the heat wave and meteor show-

ers hypotheses to describe the spillover effect among different capital markets . By

examining US, UK, and Japan stock index futures markets, they confirm the existence

of spillover effects between the US and UK markets, but not for Japan index futures.

Booth and So (2003) examine the volatility spillover effects between the DAX index,

DAX futures, and DAX options. They confirm significant volatility spillover processes

among the underlying, futures, and options markets. The authors observe that their

3

The volatility spillover effect, then dubbed the “meteor showers hypothesis,” is first identi-

fied in Engle et al. (1990) in a study of foreign exchange markets.

702 ©2017 Korean Securities Association

C.-Y. Chan et al.