Evidence on the Efficiency of Index Options Markets

volume indicates. Index options give market participants the ability to participate in anticipated market movements without having to buy or sell a large number of securities, and they permit portfolio managers to limit downside risk. Given their prominence and functions, the pricing efficiency of these markets is of great importance to academics, practitioners , and regulators. Well-functioning financial markets are vital to a thriving economy because these markets facilitate price discovery, risk hedging, and allocating capital to its most productive uses. Inefficient pricing of index options indicates that their market (and, possibly , other financial markets) is not doing the best possible job at these important functions. To detect inefficient pricing (often called mispricing) requires computing a theoretically efficient price or price range and comparing it with prices of options traded in financial markets. But valuing an index option in theory is complicated and challenging. One popular approach to deriving option pricing relationships is based on a principal called no-arbitrage. This approach is a very powerful tool in the valuation of financial assets because it does not make strong assumptions about traders' behavior or market price dynamics. The principle simply assumes that arbitrageurs enter the market and quickly eliminate mispricing if a riskless profit opportunity exists. An arbitrageur is an individual who takes advantage of a situation in which securities are mispriced relative to each other. The arbi-trageur buys the underpriced asset and sells the overpriced asset, locking in a riskless profit. In doing so, the arbitrageur drives the price of the underpriced asset up and the price of the over-priced asset down, thus eliminating mispricing. However, in a well-functioning economy—where there are no free lunches—there is no portfolio of assets that has zero cost today and a certain, positive payoff in the future. Similarly, there is no port