Information efficiency on option markets

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Mittnik & Rieken (2000) research the German Dax index option market. To enabling answering their research question of information efficiency of the German Dax index option market they apply the put-call parity (PCP) theory. Given that the Dax index option market is information efficient, options of the call type should be efficiently priced relative to identical puts. Hence the sum of both portfolios in the PCP test should equal zero, otherwise arbitrage opportunities exist on the market and thus violates the condition for an information efficient market. The results reject the hypothesis of market information efficiency on the Dax index option market. Although potential arbitrage opportunities do exists on the market using the PCP, the authors claims that due to restrictions of short selling in Germany, taking full advantage of these differences is not possible. Due to the short selling restrictions, the German Dax index option market is regarded as market information efficient according to (Mittnik & Rieken, 2000).

Information efficiency of warrant markets

Though warrants differ from options in some sense, similar methods can be applied when viewing the efficiencies of the warrant market. For instance Chan et al. (2010) applies a GARCH (1.1) IV model, similar to that of Claessen & Mittnik (2002), to research the information efficiency of the UK covered warrant market. In their study they perform a bootstrap procedure built upon the GARCH (1.1) IV model to test their hypothesis of market informational efficiency. Further they also conduct a Stochastic Dominance Test, where they test whether holding a portfolio of warrants yields more utility than holding a portfolio of the corresponding underlying assets of the warrants. The applied Stochastic Dominance Test suggests that both of the portfolios yield the same amount of utility. Additional, the information efficiency test where the GARCH (1.1) IV model is used, shows that 75% of the examined warrants efficiently reflects the information regarding past returns of the underlying stock price. Thus confirming the first test and further strengthen the findings of informational efficiency at the UK warrant market.

Article summary and contributions to the thesis subject

Previous articles tackling the subject of information efficiency on warrant markets, shows that the results are mixed. For instance, the findings from Chan et al. (2010) accepts the hypothesis of warrants being informational efficient, Koorts & Smit (2002) and Majewska & Majewski (2005) rejects this. Although the results among these differ, they all apply the B&S model to research the information efficiency. In line with these articles this thesis will apply the B&S model. Furthermore Chan et al. (2010) and Majewska & Majewski (2005) utilize the null hypothesise of information efficiency. Due to the utter importance of information efficiency and previous research in this area, it´s assumed that the Swedish plain vanilla warrants included in this thesis are ideally for capital allocation. Information efficiency is crucial for factors such as hedging, speculation functions and price discovery (Chan et al. 2010; Capelle-Blancard & Chaudhury, 2001; Brunetti & Torricelli, 2005)

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Market information efficiency and Market structure

In 1900 the French mathematician Bachelier introduced the concept of market information efficiency. He suggested that the market price reflects events, both in the past, future and present. Hence, arbitrage opportunities in an information efficient market does not exist (Dimson & Mussavian, 1998). The importance of information efficiency in capital markets, such as the Swedish plain vanilla warrant market is crucial, as factors like capital allocation, price discovery and risk management rely on this. In fact none information efficient operating market might even affect the growth rate of the market (Capelle-Blancard & Chaudhury, 2001; Brunetti & Torricelli, 2005). Closely related to the efficiency of a market, is the market structure (Case & Fair, 2007). There are four types of market structures, perfect competiveness, oligopoly, monopolistic competition and monopoly (Perloff, 2008). In a perfect competitive market, buyers and seller are assumed to be price takers. Hence, nor the customers, or the sellers can influence on the prices. This is solely determined by the market.

Models for testing information efficiency and market structure on warrant markets

Since the warrant market has certain regulations of shorting puts and calls, using the PCP model which is often applied when researching information efficiency on the option market is not applicably (Koorts & Smit, 2002). Hence to test for the information efficiency alternative methods must be adapted. This thesis will first use a similar method as (Majewska & Majewski, 2005). Here the theoretical options/warrant prices generated from a model is compared with the actual market price (Mittnik & Rieken, 2000; Majewska & Majewski, 2005). As the B&S model has been used in all previous articles researching this area and contains the assumption of no arbitrage, which is definition of information efficient markets, applying this model is suitable (Majewska & Majewski, 2005). By limiting the research such that only warrants near ITM or ATM are included, the B&S model should generate the same theoretical prices as the actual market price in an information efficient market (Veld, 2000; Green & Figlewski, 1999; Leonard & Solt, 1990; Majewska & Majewski, 2005).

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