The Efficiency of the London Traded Options Market: the Implications of Volatility, Volume, and Bid-Ask Spreads

Abstract

This study is a test of the efficiency of the London Traded Options Market. Because it uses the Black-Scholes Option Pricing Model, it is also a test of option pricing. In the process of examining call option price behaviour it investigates the effects of three empirical factors. First, it investigates the effect of a non-constant share price volatility. Hitherto, there has been no agreed procedure on modelling or forecasting the future share price volatility. This study shows that the GARCH process has the best forecasting accuracy. The ex ante GARCH volatility estimate is then incorporated in the Black-Scholes model. Because the volatility is assumed constant in the Black-Scholes model, the consideration of adapting the GARCH volatility into the model sheds insight on bridging empirical results and theoretical requirements. Second, because the London Traded Options Market is thinly traded the quoted prices may not reflect prices at which trade did or could take place. However, information on call option trading volume may not be available. This study develops and implements an analytical criterion to select the most actively traded call options. The call options selected by this criterion bear the basic characteristics of those frequently traded call options where trading volume is available. Third, this study uses the bid and ask quotations for shares and call options to test the efficiency of the London Traded Options Market. By incorporating the bid-ask spread directly in the establishment of arbitrage portfolios, an accurate assessment of transactions data can be made. The results of incorporating these factors in the test for market efficiency reveal that, despite the identification of mispriced call options, it would not have been possible to exploit the mispricing by setting up arbitrage portfolios. It must therefore be concluded that the London Traded Options Market was trading efficiently over the period of this study.