The mispricing of US index options surrounding geopolitical event
LE3 .A278 2018
Bachelor of Business Administration
The rising interdependence of global economies has raised concerns for the world’s capital markets, specifically in relation to the increasing number negative shocks following unanticipated events. The work of Gemmill (1991) has provided empirical evidence indicating that global option markets exhibit varying levels of inefficiency surrounding political events. The current research study seeks to expand on the previous literature by examining whether or not US index options display higher levels of inefficiency surrounding 11 geopolitical events that occurred between January 1, 2015 and December 31, 2016. Two hypotheses are tested in the current study using the percentage of theoretical price (IFF) as the measure of an index options level of inefficiency, relative to the Black-Scholes Option Pricing Model. The hypotheses aim to determine if the occurrence of a geopolitical event, or a rise in geopolitical risk will further deteriorate option market efficiency. Results determined that an increase in geopolitical risk increases the level of mispricing for a given index option. However, the increase is economically insignificant. Option markets capture geopolitical risk by pricing geopolitical uncertainty into equity index options. The analysis of event periods surrounding the selected geopolitical events reveals evidence that index options have lower levels of mispricing before and after the event occurs. Robustness tests were conducted using additional or augmented control variables but findings remained similar. The data supports current literature stating that option markets exhibit periods of inefficiency, but further research is required to fully explain the relationship between geopolitical events and option market inefficiency.
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