Introduction

An option is the right to buy or sell an asset for a specified price, called the strike or exercise price, on or before a specified expiration date (Bodie et al, 2009). The underlying assets in this case are the shares of a company. Options are used by investors to hedge their capital gains risk. Call options are bought when the market is expected to rise (bull market) and put options are bought when the market is expected to fall (bear market).

Since 2007, global financial markets have been bearish and at the same time very volatile. Due to this, investors have been hedging their increased risk by investing in the option markets.

Option prices are determined by the information available in the market regarding a particular company. If a company announces positive news, the call option price of that particular share will increase (for the same strike price). The opposite will happen with the price of a put option. If good news regarding a company comes into the market, the price of the put option will decrease.

However, it has been argued that because, in practice, markets are not fully efficient (i.e. don’t follow the strong form of efficiency) it is possible for (privately known) insider information regarding companies to “leak” into the markets and affect the prices of options. This is known as the semi-strong form of efficiency and is what exists in the real world.

The purpose of this research is to see whether or not such insider information affects the prices of options before the information is publicly announced. The focus of this research will be on the global financial crises, which started in 2007.

Literature Review

Donald P. Chiras and Steven Manaster (1978) talked about market efficiency and the effect on option prices in their paper “The Information Content of Option Prices and a Test of Market Efficiency”. They used the Black-Scholes (1973) option pricing model to calculate the equilibrium price of stock purchase options. However, the Black-Scholes model assumes no dividends, so Merton (1973) adjusted the model to include dividend. Dividends in this case were assumed to be paid continuously such that the yield was constant. Merton implied that the standard deviation was the value of the stock’s standard deviation of returns, which when analysed in the option pricing formula will equate an observed option price calculated from the option formula.

Chiras and Manaster found that the prices observed for different options on the same stock resulted in different calculated implied standard deviations. Their hypothesis was tested by trying to identify over and underestimated priced option prices. They found that the “model tended to over estimate the value of an option on a high variance security, whilst market traders tended to underestimate the value. And similarly, while the model tended to underestimate the value of the option on a low variance security, traders tended to over estimate it” [Black and Scholes (1972, pp. 416-417)]. In other words, the tests indicated that the actual price at which options are bought and sold deviate in certain systematic ways from the values predicted by the formula. Option buyers pay prices which are consistently higher than those predicted by the formula.

Allen M. Poteshman (2006) tried to prove the statement that insider information can affect the financial markets. He concluded that terrorists and/or their associates had traded in the option market on advanced knowledge of the September 11 attacks. According to Poteshman, the put-call ratios of American Airlines’ and United Airlines’ options were abnormally high just days before the eleventh of September. He even stated that the masterminds behind the attacks had used the attacks as a means of financing their terrorist activities.

Allen M. Poteshman (2006) also proved that markets become inefficient due to the “non-public information possessed by option traders rather than the market inefficiency” itself. Furthermore, Allen M. Poteshman (2001) cited Stein (1989) stating that due to market inefficiencies there was long-term overreaction to information in the S&P100 Index options market in the mid-1980s. However, currently, there is no short-term under reaction in the same market. Also, Reza S. Mahani and Allen M. Poteshman (2006) found that unsophisticated option market investors overreacted to past news on underlying stocks, which proves yet again that the only people who take advantage of market inefficiencies are people who carry out insider dealing, and as Poteshman (2006) stated (above) that markets become inefficient due to the privately-held information by option holders rather than the market inefficiency itself.

Another proof of market inefficiency was given by R.L. Varson and M.J.R Selby (1997). Through examination they found that just five days before a company announced its earnings, the option prices would lead their corresponding share price by approximately fifteen minutes. This proves that even though the announcement wasn’t made yet, it was already incorporated in the option prices of the corresponding share price: proof of insider information, i.e., market inefficiency. Reza S. Mahani and Allen M. Poteshman (2006) also stated that unsophisticated investors overreact to past news; they buy more options on growth stocks just before the earnings announcement is made. This is true even though the value stocks outperform the growth stocks by a wide margin.

Brian D. Kluger AND Steve B. Wyatt (1995) carried out a test to find the information aggregation role of options when agents possessed diverse information about possible asset returns. They found that options speed the information aggregation process in the financial markets. This means that if there were no options in the financial markets, then insider information wouldn’t have the same effect as it does currently. In other words, the financial markets would probably not have been as inefficient as they are now.

Research Objectives

The objectives of this research are the following:

To see if the semi-strong form of market efficiency holds in practice

I.e., whether or not insider information affects option prices (before the official announcement is made).

If yes, how did that information affect the prices of the options in question?

Did the prices increase or decrease?

Can arbitrage profits be made due to the market inefficiencies?

By looking at historical data, decide on how long insider information generally stays in the market before it is publicly available?

I.e., the amount of time insider investors have to make arbitrage profits, if any.

Was the 2007 financial crisis predictable by looking at/analysing the option prices then?

Research Design

The research method for this project will be of a quantitative nature. The model to be used to price the options is the Black-Scholes Option Pricing Mode