This paper applies a game theory approach to examine the effects of a market structure change in options trading from a monopoly to a Cournot-type oligopoly that occurred in two successive periods on the Montreal exchange. We analyze the intra-day behaviour of option bid-ask spreads and find that cross-listing has a differential impact on spreads, affecting quoted but not effective spreads under oligopoly. We also find that the impact of the change in structure on effective spreads comes mostly from an increase in limit orders and is consistent with a switch from Cournot to Bertrand-type strategic behaviour for such orders. We conclude that market structure effects within an options exchange are enough to realize most of the benefits of inter-market competition even in the context of market thinness.

We generalize the asset dynamics assumptions of Leland (1994b) and Leland and Toft (1996) to a state dependent variance with constant elasticity process (CEV) and obtain analytical solutions for corporate debt and equity value. We use the GMM technique to extract the parameters by fitting the empirical data in the equity and credit default swap markets simultaneously. We find that the elasticity parameter is significantly different from zero for most of the firms and that the CEV model performs much better than the model with constant volatility in both in-sample fittings and out-of-sample predictions of CDS spreads.

We present a new approach to the pricing of catastrophe event (CAT) derivatives that does not assume a fully diversifiable event risk. Instead, we assume that the event occurrence and intensity affect the return of the market portfolio of an agent that trades in the event derivatives. Based on this approach, we derive values for a CAT option and a reinsurance contract on an insurer’s assets using recent results from the option pricing literature. We show that the assumption of unsystematic event risk seriously underprices the CAT option. Last, we present numerical results for our derivatives using real data from hurricane landings in Florida.

ABSTRACT Upper and lower bounds are derived for call options traded at discrete intervals. These bounds are independent of assumptions on the stock price distribution other than a restriction satisfied by the stock being “non‐negative beta.” The development of the bounds relies on the single‐price law and arbitrage arguments. Both single‐period and multiperiod results are produced, and put option bounds follow by extension. The bounds exist as equilibrium values given a consensus on stock price distribution; they are also valid for empirical studies, being adjustable for dividends and commissions.

We document widespread violations of stochastic dominance by one-month S&P 500 index call options market over 1986-2006. These violations imply that a trader can improve her expected utility by engaging in a zero-net-cost trade. We allow the market to be incomplete and also imperfect by introducing transaction costs and bid-ask spreads. Even though pre-crash option prices conform to the Black-Scholes-Merton model reasonably well, they are incorrectly priced if the distribution of the index return is estimated from time-series data even with a variety of statistical adjustments. Even though there are fewer violations by OTM calls than by ITM calls, there are still substantial violations by OTM calls, contradicting the inference drawn from the observed implied volatility smile that the problem primarily lies with the left-hand tail of the index return distribution. Most of the violations by post-crash options are not due to the smile being too steep: options are underpriced over 1988-1995 and overpriced over 1997-2006. The decrease in violations over the post-crash period 1988-1995 is followed by a substantial increase in violations over 1997-2006. These results do not support the hypothesis that the options market is becoming more rational over time. Current draft: November 10, 2006 JEL classification: G13 Keywords: Derivative pricing; volatility smile, incomplete markets, transaction costs; index options; stochastic dominance bounds We thank workshop participants at the German Finance Society Meetings 2004, the Bachelier 2004 Congress, the EFA 2005 Meetings, the Frontiers of Finance conference 2006, the Alberta/Calgary 2006 conference, the Universities of Chicago, Iowa, Southern California, Maryland, Texas-Austin, Torino, Utah and Concordia, Laval, New York, Princeton and St. Gallen Universities and, in particular, Yacine Ait-Sahalia, David Bates, Duke Bristow, Larry Harris, Steve Heston, Jim Hodder, Mark Loewenstein, Matthew Richardson, Jeffrey Russell, Hersh Shefrin and Greg Willard for their insightful comments and constructive criticism. We also thank Michal Czerwonko for excellent research assistance. We remain responsible for errors and omissions. Constantinides acknowledges financial support from the Center for Research in Security Prices of the University of Chicago and Perrakis from the Social Sciences and Humanities Research Council of Canada. E-mail addresses: [email protected], [email protected], [email protected].

ABSTRACT American options on the S&P 500 index futures that violate the stochastic dominance bounds of Constantinides and Perrakis (2009) from 1983 to 2006 are identified as potentially profitable trades. Call bid prices more frequently violate their upper bound than put bid prices do, while violations of the lower bounds by ask prices are infrequent. In out‐of‐sample tests of stochastic dominance, the writing of options that violate the upper bound increases the expected utility of any risk‐averse investor holding the market and cash, net of transaction costs and bid‐ask spreads. The results are economically significant and robust.