Asymmetric Mispricing and Regime‐dependent Dynamics in Futures and Options Markets

• Author: Jaeram Lee,Doojin Ryu
• DOI: http://doi.org/10.1111/asej.12084
• Date: 01 March 2016
• Published date: 01 March 2016

Asymmetric Mispricing and Regime-dependent

Dynamics in Futures and Options Markets*

Jaeram Lee and Doojin Ryu

Received 9 May 2014; accepted 26 November 2015

We examine regime-dependent price dynamics and mispricing adjustments within the

KOSPI200spot, futures andoptions markets throughan analysis of data from January

2000 to December 2014. Investors exploit mispricing between derivatives and spot

markets only if mispricing is sufficiently large. The futures traders take long, rather

than short, positions to adjust for mispricing. Mispricing between spot and options

markets is adjusted by trading options and not by trading spots. We find the

bidirectional information flows between spot and futures markets when the futures-

implied index is sufficiently larger than the spot index. In contrast, no significant

lead–lag relationshipbetween spot andoptions markets exists.Significant asymmetric

transactioncosts exist in the spot marketand this asymmetry has decreasedover time.

Keywords: KOSPI200 futures and options, limited dependent variable model,

mispricing, threshold vector error-correction model, transaction costs.

JEL classification codes: G13, G14, G32.

doi: 10.1111/asej.12084

I. Introduction

Mispricing in derivatives markets can be defined as the difference between the

theoretical underlying asset price under no-arbitrage conditions, such as the

cost-of-carry hypothesis (in the case of futures) or put-call parity (in the case of

options), and its market price. Many studies examine the dynamics of mispricing

in relation to market conditions from this perspective. For example, MacKinlay

and Ramaswamy (1988) argue that the difference between the futures price and

its theoretical price in the spot market is limited due to transaction costs; however,

it increases with time-to-maturity. Ofek et al. (2004) find that the extent of the put-

call parity violations in the US individual options market is significantly related to

the cost of short-selling. Cremers and Weinbaum (2010) claim that mispricing,

represented by the deviation from put-call parity, predicts underlying returns.

In order to examine the mispricing issue within derivatives and commodities

markets, certain innovative studies adopt a threshold vector error-correction model

* Lee: Collegeof Business, KAIST,85 Hoegiro, Dongdaemun-gu, Seoul,Korea. Ryu (corresponding

author): College of Economics, Sungkyunkwan University, 25-2, Sungkyunkwan-ro, Jongno-gu, Seoul

03063,Korea. Email: sharpjin@skku.edu. Weare grateful forthe helpful comments and suggestions from

Jangkoo Kang,Baeho Kim, Bum Suk Kim, Heejin Yang and allthe participants of the SKKU financial

economicsseminar. This workwas supported by a NationalResearch Foundation ofKorea Grant funded

by the KoreanGovernment (NRF-2014S1A5B8060964).

© 2016 East Asian Economic Association and John Wiley & Sons Australia, Ltd

Asian Economic Journal 2016, Vol.30 No. 1, 47–65 47

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(TVECM) framework,because it effectively captures the nonlinear dynamicsof as-

set prices. Dwyer et al. (1996) claim that, in comparison to alternative linear

models, a three-regime TVECM can explain the mispricing adjustments and price

dynamics of the S&P500 spot index and its futures prices more effectively. Kim

et al. (2010) confirm that the prices of S&P500 futures lead the nonlinear mean-

reverting dynamics of the underlying asset using a three-regime TVECM. Certain

studies employing the TVECM analyze commodities markets. Peri and Baldi

(2010) examine the asymmetric dynamic adjusting processes between commodity

oil prices using the two-regime TVECM. Their findings show that among the oil

commodities, only the price of rapeseed oil adjusts asymmetrically to its long-

run equilibrium level, which is determined by diesel prices; this has policy impli-

cations for the remodeling of energy portfolios.

As demonstrated by these studies, TVECM is a powerful tool to examine the non-

linear price dynamics and relationships among related financial markets; however, the

majority of previous studies examine the price dynamics of US and European mar-

kets. The lack of research on relatively immature emerging and/or Asian markets,

where nonlinear relationship and mispricing issues are more frequently observed

and may have a more significant impact, is surprising. Furthermore, most of the re-

search on derivatives markets using TVECM analyzes the relationship between index

futures only; these have simpler payoff structures in comparis on to oth er deriva-

tives. Because options have nonlinear payoff structures and highly complicated

price dynamics in comparison to futures, an empirical analysis of option price

dynamics using TVECM is also meaningful.

1

In addition, it should be consid-

ered that the price dynamics among the underlying spot, futures and options are

closely related and the information flows between them are highly significant

(Schlag and Stoll, 2005; Ryu, 2011; Chang et al., 2013) as investors usually

maintain positions in both futures and options markets. However, most of the

previous studies analyze only a part of these markets.

2

The aforem entioned lim itations of p revious studi es motivate us to exa mine

the mispricing and regime-dependent price dynamics issues within the

KOSPI200 futures and options markets together using the TVECM frame-

work. KOSPI200 futures and options, the two most representative index

derivatives on th e Korea Exchange ( KRX), are fam ous for thei r tremendous

trading volumes and are of great interest to both global and local investors.

In addition to their ample market liquidity, the futures and options markets

facilitate an ideal setting to investigate issues due to various other factors.

Previous stu dies on the KOSPI20 0 index derivatives ma rkets consis tently

1 Although some recent studies, such as Lee and Ryu (2014) and Lu et al. (2012), indirectly examine

option price dynamics by analyzing implied volatilities derived from options markets under the

TVECM framework, these studies fail to cover mispricing andtransaction cost issues.

2 Exceptionally, Lee etal. (2015) employ the TVECM to investigate the nonlinear relationships

among these three markets. However,they focus on the common information, instead of the mispricing

adjustments, in the markets.

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© 2016 East Asian Economic Association and John Wiley & Sons Australia, Ltd