Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Wed, 28 Nov 2018

Earnings related trading: Futures or Options

There is a large body of literature (mainly in the US) that a lot of the trading activity in response to earnings information happens in the options market. (The seminal paper in this field is Roll, R., Schwartz, E., & Subrahmanyam, A. (2010). O/S: The relative trading activity in options and stock. Journal of Financial Economics, 96(1), 1–17.) Unfortunately, the US and most other countries do not have a liquid single stock futures market, and so we do not know whether the options market was the preferred choice of the informed traders or it was the second best choice substituting for the missing first choice (the futures market). If what the informed trader wanted was leverage and short selling ability, the futures are a much better vehicle because there is no option premium and no delta rebalancing cost. On the other hand, if the trader believed for example that there was a high probability of a large upside surprise in the earnings, counterbalanced by a more modest risk of downside surprise, then the sensible way to express that view would be with a bull-biased strangle (buy a substantial number of out-of-the-money calls and a somewhat smaller number of out-of-the-money puts). It would be too risky to trade this view in the futures market without the downside protection provided by options.

India provides the perfect setting to resolve this issue because it has liquid single stock futures and single stock options markets (both of these markets are among the largest such markets in the world). In a recent paper, my doctoral student, Sonali Jain, my colleagues, Prof. Sobhesh Agarwalla and Prof. Ajay Pandey and I investigate this (Jain S, Agarwalla SK, Varma JR, Pandey A. Informed trading around earnings announcements – Spot, futures, or options?. J Futures Markets. 2018. https://doi.org/10.1002/fut.21983) We find that in India single stock futures play the role that the options market plays in the US implying that the informed traders are seeking leverage benefits of derivatives rather than the nonlinear payoffs of options. We also find patterns in the data that are best explained by information leakage. Though, Indian derivative markets are often disparaged as being gambling dens dominated by noise traders, our results suggest that the futures markets are also venues of trading based on fundamentals.

Posted at 18:16 on Wed, 28 Nov 2018     View/Post Comments (0)     permanent link


Thu, 15 Nov 2018

Spreads price constraints

Craig Pirrong writes on his Streetwise Professor blog that “Spreads price constraints.” Though Pirrong is talking about natural gas calendar spreads, I think this is an excellent way of thinking about many other spreads even for financial assets. In commodities, the constraints are obvious: for calendar spreads, the constraint is that you cannot move supply from the future to the present, for location spreads, the constraints are transportation bottlenecks, for quality spreads, technological constraints limit the elasticity of substitution between different grades (in case of intermediate goods), while inflexible tastes constrain the elasticity in case of final goods.

But the idea that “spreads price constraints” is also true for financial assets where the physical constraints of commodities are not applicable. The constraints here are more about limits to arbitrage – capital, funding, leverage and short-sale constraints, regulatory constraints on permissible investments, and constraints on the skilled human resources required to implement certain kinds of arbitrage.

Thinking of the spread as the shadow price of a constraint makes it much easier to understand the otherwise intractable statistical properties of the spread. Forget about normal distributions, even the popular fat tailed distributions (like the Student-t with 3-10 degrees of freedom) are completely inadequate to model these spreads. Modelling the two prices and computing the spread as their difference does not help because modelling the dependence relationship (the copula) is fiendishly difficult (see my blog post about Nordic power spreads). But thinking about the spread as the shadow price of a constraint, allows us to frame the problem in terms of standard optimization theory. Shadow prices can be highly non linear (even discontinuous) functions of the parameters of an optimization problem. For example, if the constraint is not binding, then the shadow price is zero, and changing the parameters makes no difference to the shadow price until the constraint becomes binding, at which point, the shadow price might jump to a large value and might also become very sensitive to changes in various parameters.

This is in fact quite often observed in derivative markets – a spread may be very small and stable for years, and then it can suddenly shoot up to very high levels (orders of magnitude greater than its normal value), and can also then become very volatile. If the risk managers had succumbed to the temptation to treat the spread as a very low risk position, they would now be staring at a catastrophic failure of the risk management system. Risk managers would do well to refresh their understanding about duality theory in linear (and non linear) programming.

Posted at 17:43 on Thu, 15 Nov 2018     View/Post Comments (0)     permanent link


Wed, 07 Nov 2018

Aadhaar and signing a blank sheet of paper redux

The Aadhaar abuse that I described a year ago as a hypothetical possibility a year ago has indeed happened in reality. In July 2017, I described the scenario in a blog post as follows:

That is when I realized that the error message that I saw on the employee’s screen was not coming from the Aadhaar system, but from the telecom company’s software. … Let us think about why this is a HUGE problem. Very few people would bother to go through the bodily contortion required to read a screen whose back is turned towards them. An unscrupulous employee could simply get me to authenticate the finger print once again though there was no error and use the second authentication to allot a second SIM card in my name. He could then give me the first SIM card and hand over the second SIM to a terrorist. When that terrorist is finally caught, the SIM that he was using would be traced back to me and my life would be utterly and completely ruined.

Last week, the newspapers carried a PTI report about a case going on in the Delhi High Court about exactly this vulnerability:

The Delhi High Court on Thursday suggested incorporating recommendations, like using OTP authentication instead of biometric, given by two amicus curiae to plug a ‘loophole’ in the Aadhaar verification system that had been misused by a mobile shop owner to issue fresh SIM cards in the name of unwary customers for use in fraudulent activities. The shop owner, during Aadhaar verification of a SIM, used to make the customer give his thumb impression twice by saying it was not properly obtained the first time and the second round of authentication was then used to issue a fresh connection which was handed over to some third party, the high court had earlier noted while initiating a PIL on the issue.

This vindicates what I wrote last year:

Using Aadhaar (India’s biometric authentication system) to verify a person’s identity is relatively secure, but using it to authenticate a transaction is extremely problematic. Every other form of authentication is bound to a specific transaction: I sign a document, I put my thumb impression to a document, I digitally sign a document (or message as the cryptographers prefer to call it). In Aadhaar, I put my thumb (or other finger) on a finger print reading device, and not on the document that I am authenticating. How can anybody establish what I intended to authenticate, and what the service provider intended me to authenticate? Aadhaar authentication ignores the fundamental tenet of authentication that a transaction authentication must be inseparably bound to the document or transaction that it is authenticating. Therefore using Aadhaar to authenticate a transaction is like signing a blank sheet of paper on which the other party can write whatever it wants.

Posted at 18:15 on Wed, 07 Nov 2018     View/Post Comments (0)     permanent link


Fri, 02 Nov 2018

Indian Single Stock Option Pricing

A recent paper by my doctoral student, Sonali Jain, my colleague, Prof. Sobhesh Agarwalla and myself (Jain S, Varma JR, Agarwalla SK. Indian equity options: Smile, risk premiums, and efficiency. J Futures Markets. 2018;1–14. https://doi.org/10.1002/fut.21971) studies the pricing of single stock 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.”

The good news here is that (a) options with different strikes on the same stock are nicely consistent with each other (parsimonious smile), and (b) the option market predicts future volatility instead of blindly extrapolating past volatility. The troubling part is that the implied volatility of Indian single stock options consistently exceeds realized volatility by too large an amount to be easily explained as a rational risk premium. Globally, there is a substantial risk premium in index options but not so much in single stock options in accordance with the intuition that changes in index volatility are a non diversifiable risk, while fluctuations in the idiosyncratic volatility of individual stocks are probably diversifiable. The large gap between Indian implied and realized volatility is therefore problematic. However, the phenomenon cannot be attributed entirely to an irrational market: we find that the single stock implied volatility has a strong systematic component responding to changes in market wide risk aversion (the index option smile).

There is a puzzle here that demands further research. There is some anecdotal evidence that option writers demand a risk premium for expiry day manipulation by the promoters of the company. I also think that there is a shortage of capital devoted to option writing despite the emergence of a few alternative investment funds in this area. Perhaps there are other less well understood barriers to implementing a diversified option writing strategy in India.

Posted at 13:41 on Fri, 02 Nov 2018     View/Post Comments (0)     permanent link