Tests of the put-call parity relation using options on futures on the S&P 500 Index

Urbi Garay*, Mar a Celina Ordo n ez and Maximiliano Gonza lez *Instituto de Estudios Superiores de Administracio n (IESA), Av. IESA, Edif. IESA, San Bernardino, Caracas, 1010, Venezuela. Tel. 58 212 555 4242; Fax. 58 212 555 4446; E-mail: urbi.garay@iesa.edu.ve Received (in revised form): 6th May, 2003
Urbi Garay is Assistant Professor of Finance at the Instituto de Estudios Superiores de Administracio n (IESA) in Caracas, and is associated with the Center for International Studies and Derivatives Markets (CISDM) at the University of Massachusetts, Amherst. He holds an MA in International Economics from Yale University and a PhD in Finance from the University of Massachusetts, Amherst. Mar a Celina Ordo n ez is Accounting and Financial Reporting Services IT Manager at Procter & Gamble Latin American headquarters in Caracas. She joined P&G in 1996, and holds a Masters degree in Finance from IESA in Caracas. Maximiliano Gonza lez is Assistant Professor of Finance at IESA in Caracas. He holds an MBA from IESA, and a Masters degree in Management and a PhD in Finance from Tulane University.

Practical applications This paper investigates the well-known put-call parity (PCP) relation using options on futures on the Standard and Poors 500 (S&P 500) Index. The authors verify that when transaction costs commission costs and bid-ask spreads on options and on futures are included in the model, arbitrage opportunities are translated into the possibility of a gain well below $1,000 for an option contract on futures on the S&P 500. This amount does not represent an economically signicant value, especially if it is noted that other factors such as taxes have not been considered in this paper. These results offer support to the efcient market theory. Abstract This paper investigates the put-call parity (PCP) relation using options on futures on the Standard and Poors 500 (S&P 500) Index using daily closing options and futures prices between 2nd January and 31st December, 2001. Results obtained demonstrate that the inclusion of transaction costs in the model considerably reduces

Derivatives Use, Trading & Regulation, Vol. 9 No. 3, 2003, pp. 259280 Henry Stewart Publications, 1357-0927

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the number of times that a violation of the PCP relation occurs at the same time that it diminishes the magnitude of the distortion. Similarly, the PCP relation applies more accurately to those options that are the nearest to being at-the-money. When deep out-of-the-money or deep in-the-money options were used in the tests the number of violations increased. This may be the result of the low liquidity levels of these contracts. Finally, the authors verify in this study that when transaction costs commission costs and bid-ask spreads on options and on futures are included in the model, arbitrage opportunities are translated in the possibility of a gain well below $1,000 for an option contract on futures on the S&P 500. This amount does not represent an economically signicant value, especially if it is considered that other factors such as taxes have not been considered in this paper. These results offer support to the efcient market theory.

could be translated into arbitrage opportunities. This paper investigates the PCP relation using options on futures, more specifically, options on futures on the Standard and Poors 500 (S&P 500) Index. These contracts are traded on the Chicago Mercantile Exchange (CME). The authors inquire whether any pattern of violation of the PCP relation is present and to what extent transaction costs and liquidity could reasonably explain any possible distortions. Following this, there is a section presenting the different PCP relations that have been proposed in the literature, and a review of the empirical literature. The next section presents the data and methodology followed to test the PCP relation in the study; the final section presents the results obtained and concludes the paper.

INTRODUCTION Numerous empirical studies about the put-call parity (PCP) relation have been conducted in the American, European and Australian stock and stock index options markets. Some of these studies have concluded that distortions in the price of options are caused by transaction costs. Other research has found that violations to the PCP relation can be attributed to incorrect sampling and to the use of non-synchronous data. Finally, it has been verified that some markets present inefficiencies that cannot be explained by transaction costs, and that these inefficiencies

PUT-CALL PARITY RELATIONS The basic put-call parity relation (Stoll) The PCP relation is a theoretical derivation initially outlined by Stoll.1 Stoll established a relation between the prices of a put and a call option written on the same underlying asset, having the same exercise price and the same expiration date. Stoll makes the following assumptions in his derivation: there are no transaction costs; options are always exercised on their date of expiration and never before this date; underlying assets

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do not pay dividends during the life of the option contract or, in their defect, options are protected against dividend payments; there are no arbitrage opportunities, borrowers and lenders can become indebted themselves or lend money at the risk-free rate of interest. Under these assumptions, Stoll demonstrates that buying a put (P) is the same as buying a call option (C) on the same stock, with the same expiration date (T) and strike price (K) combined with a short position in the underlying asset (S) plus the loan of an amount of money equivalent to the value of the exercise price discounted at the risk free rate of interest (r): C S P Ke .
rT

stocks that do not pay dividends or that they are protected against the payment of dividends, it is certain that an American call option should not be exercised before its expiration date and, therefore, an American call should have the same value as an European call option. On the other hand, the case is not the same for put options because if, at some moment, the underlying asset reaches a value near zero, the put option would have to be exercised, since this would be a situation in which there would exist a large possible gain. With this reasoning, Merton proposes the following inequality that must be fullled for American options: S K C P S KerT The PCP relation and the effect of dividend payments (Klemkosky and Resnick, and Cox and Rubinstein) Based on the study of the effect of dividend payments made by Klemkosky and Resnick,3,4,5 Cox and Rubinstein6 present two propositions The rst proposition presents the effects of dividends on the PCP relation for European options whose underlying stocks pay well-known dividends (D) and that are not protected against them. This relation appears next: C D KerT P S (4) (3)

(1)

Rearranging terms, Stoll obtains the PCP relation: C Ke P S

rt

(2)

According to Stoll, since investors should not exercise options prior to their expiration dates, the relation outlined in (2) should hold for both American and European options. The modied PCP relation for American options (Merton) Merton makes a comment on the work of Stoll in which he argues that, assuming that both put and call options are written on
2

The second proposition shows the effects of dividends on the PCP relation for

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American options whose underlying stocks pay well-known dividends and that are not protected. This relation is: S D K C P S KerT (5)

If dividends are uncertain, equations (4) and (5) are modied as presented in equations (6) and (7), respectively: (4) > C D+ KerT P+S C D KerT (5) > S D+ K C P S KerT Where D+ represents the maximum expected dividends and D represents the minimum expected dividends. The PCP relation and the effect of transaction costs The previous derivations of the PCP relation are based on the assumption that transaction costs do not exist. Cusack7 studies the following relation for both European and American options whose underlying stocks do not pay dividends: S K TCu C P S KerT TCo

call option that is overvalued. Both TCu and TCo should include: broker commissions, stock-market commissions and taxes. Bid-ask spreads represent another component of transaction costs that must be considered.

REVIEW OF THE EMPIRICAL LITERATURE This section presents a brief review of the empirical literature on the PCP relation in the American, European and Australian markets. But rst, the effects of the use of non-synchronous data in tests of the PCP relation are considered. Effects of the use of non-synchronous data in previous empirical studies of the PCP relation A number of previous empirical studies on the PCP relation suggest that there exist real opportunities for arbitrage in markets as a result of apparent mispricings of options. On some occasions the mispricing can be attributed to transaction costs since, in most cases, these have not been included. In other cases, however, the problem of non-synchronicity in transactions between options and the price of underlying assets can explain what appears to be a violation of the PCP relation. In this regard, and depending on the liquidity of the options and underlying assets that are used in the empirical study, a suitable form of sampling ought to be selected so that the effect of

(6) (7)

(8)

Where TCu represents those transaction costs that are attributable to an arbitrage strategy resulting from a call option that is undervalued and TCo represents the transaction costs that arise when an arbitrage strategy is followed as a result of a

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non-synchronous trading can be ameliorated. For liquid options and stock markets, Brown and Easton8 propose that the following recommendations be taken into account in the sampling process where the only information available is the closing price of options and stocks: To use the closing stock price if the spread is within the bid-ask spread, otherwise the sample must be discarded. To consider solely put and call options that fulll the following characteristics: a) They have a volume of transactions different from zero on the sampled day; b) That the date and hour of market closing is the same one that was taken for the stock; and c) That the closing price of put and call options is within the closing bid-ask spread. Previous studies of the PCP relation in the USA The PCP relation has been extensively tested in the US markets. The rst studies were made by Stoll,1 who established support for the PCP theory, and Gould and Galai.9 These two later authors found that the PCP relation held depending on the magnitude of assumed transaction costs. Later, Klemkosky and Resnick,3,4,5 Evnine and Rudd,10 and Chance11 tested the PCP relation in the American formal markets

(Chicago Board Options Exchange (CBOE), Chicago Board of Trade (CBOT), etc), nding possible inefciencies in the formal market for options in the USA). The following three important factors, which may be the cause of the possible inefciencies found, were present in these early studies: The data used were not intra-daily data and, in some cases, not even daily closing data. Most of the samples taken used weekly or monthly closing prices, thus increasing the probability of errors caused by non-synchronicity in data; Transaction costs were not taken into account. All studies were made on American options, and in many cases it was not possible to isolate the effect of the value of the early exercise of options; Since over-the-counter (OTC) transactions take place directly between nancial institutions and corporations, and not through a formal market, the registration of these transactions is not very precise. Kamara and Miller12 made an empirical study of the PCP relation on European options on the S&P 500, which is negotiated on the CBOE. The authors eliminated the problem posited by the value of the early exercise of an American option since they were using European type options contracts. Kamara and Miller

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found that the number of PCP violations was much smaller than that found in previous studies in which only American options were used. Additionally, the authors concluded that the pattern of violations of the PCP relation can be associated with a premium value that results from liquidity risk, that is, the risk that an investor incurs when he or she is trying to engage in arbitrage transactions and one of the transactions cannot be completed at the correct price. Finally, Kamara and Miller found that the frequency and the number of violations is related to moneyness (options farther from being at-the-money present a greater number of violations to the PCP relation than those that are closer to being at-the-money). Previous studies of the PCP relation in Europe Nisbet13 makes an empirical study based on negotiated American options traded on the London Traded Options Market (LTOM), using intra-daily data and including transaction costs and dividend payments. Nisbet nds that when the only transaction cost considered is the bid-ask spread a signicant number of violations of the PCP relation are present. In a second model, in which he includes the costs of commission and the effect of dividends in addition to the bid-ask spread, he nds that the volume and frequency of the violations in relation to the PCP are reduced to the point where the possibilities of potential arbitrage gains

are relatively low. In a recent paper, Capelle-Blancard and Chaudhury14 nd support for the PCP relation in France and present a review of the literature on the PCP relation in different European countries. Previous studies of the PCP relation in Australia The main studies conducted in Australia are those of Loudon,15 Gray,16 Taylor,17 Easton,18 Brown and Easton8 and Cusack.7 Loudon and Taylor each undertake empirical tests of the PCP relation in the Australian Options Market (AOM) using the same model and the same source of information. Nevertheless, they reach diametrically opposite conclusions. Brown and Easton made a study attempting to reconcile the results obtained by Loudon and Taylor. The authors next present the model employed by Loudon and Taylor, and later by Brown and Easton, as well as a comparative table of the results obtained in each study (see Table 1). C S Ke_rT P C S K Vp(D) (9) Brown and Easton obtain results that are similar to those of Loudon and conclude that the main reason why Taylors study produced different results lay in the problem of using non-synchronous data, since 60 per cent of their samples were

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Table 1: Comparison of empirical studies of the PCP relation in Australia: Loudon,15 Taylor,17 Brown & Easton8
Loudon15 Non-violations (%) Lower boundary violations (%) Upper boundary violations (%) 60 38.5 1.5 Taylor17 83.8 0 16.2 Brown and Easton8 70.8 26.3 3

invalid. Taylor only used monthly closing data and included closing data for days for which the volume of put or call transactions was zero. Additionally, Brown and Easton found some computational errors in the procedure employed to calculate the put-call values. The studies of Loudon and Brown and Easton demonstrate the existence of apparent inefciencies in the AOM. In most cases, inefciencies come from an underestimation of the price of puts (lower boundary). For this reason, apparent arbitrage opportunities were present. Gray16 makes a study on the AOM using a model that includes transaction costs, the value of early exercise of option contracts and the effects of dividends, using closing prices for options and stocks that have been traded during the day. Gray nds signicant violations of the PCP relation, even when he includes commission costs. The frequency and volume of violations is reduced, however, when transaction costs include the bid-ask spread.

Finally, Cusack7 makes an empirical study on the AOM for American options, including transaction costs (but excluding the bid-ask spread), but without including the effect of dividends and using intra-daily data for time intervals between ve and 15 minutes verifying that their results are consistent with those obtained by Loudon, Brown and Easton and Gray. These results are consistent with the existence of inefciencies in the Australian market, even when transaction costs are included in the analysis, and the use of intra-daily data versus the use of closing daily data not making a difference in the results obtained.

Data and general methodology There follows an outline of the data and general methodology used to test the PCP relation for options on futures on the S&P 500 Index: For the accomplishment of the study the information on closing prices on the

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following derivatives traded on the CME is considered: Futures contracts on the S&P 500 Index, American put option contracts on futures on the S&P 500 Index (the size of the contract is 250), American call option contracts on futures on the S&P 500 Index (the size of the contract is 250). The sample period starts on 2nd January, 2001 and ends on 31st December, 2001. The information chosen corresponds only to closing daily prices of those option contracts for which at least one transaction occurred during the day. This procedure was followed as a way to eliminate part of the problem of working with non-synchronous data. Contracts that show a price of zero on a certain date are eliminated from the sample. Only transactions made in the regular trading time were taken from the CME (regular transactions or R). All after-hours transactions were eliminated (electronic transactions or E). These transactions can be made through the GLOBEX system in night schedules (since trades on futures on the S&P 500 Index are closed in the regular period, the use of these after-hours transactions could have introduced distortions in the study because of the problem of non-synchronicity in trades). Tests of the PCP relation were undertaken for every working day of the stock market, using closing put, calls,

and futures prices of contracts that have the same maturity date and the same exercise price. This procedure diminishes part of the problem of using non-synchronous data. Yields on Treasury Bills are used as the risk-free rate of interest. The rates were taken according to the following criteria: T-bill to three months for contracts that possess from zero to three months to maturity; T-bill to six months for contracts that mature between three and six months from the day the sample was taken; T-bill to one year for contracts maturing between six months and one year. Contracts possessing the following expiration dates were considered: March, June, August and December, 2001; and March, June and September, 2002. The date of expiration of each contract was the third Friday of the expiration month. The initial contract sample, including traded volume and prices different from zero, is constituted by: 16,367 call options (number of days number of contracts) on futures on the S&P 500 Index; 22,252 put options (number of days number of contracts) on futures on the S&P 500 Index; and 1,770 futures contracts (number of days number of contracts) on the S&P 500 Index. For every working day, put and call option contracts with the same exercise price and the same expiration date to the

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futures contract are grouped. This yields a total of 2,773 samples ready to be tested for the PCP relation. The equation that is used to prove the model, without taking into account transaction costs, is (model 1): F0erT K P C F0 KerT P Where: F0 is the price of the futures contract on the S&P 500 Index; K is the exercise price; P is the price of the American put option on futures contract on the S&P 500 Index; C is the price of the American call option on futures contract on S&P 500 Index; r is the interest rate (T-bills); T is the time remaining until the option expires. The equation that is used to prove the model, taking into account transaction costs (model 2), is: F0erT K P Bid_Ask TCu C F0 KerT P Bid_Ask TCo Where: TCu represents the commission costs incurred in an arbitrage transaction when a call option is undervalued; buy a call, sell a put, short a futures contract, and invest K at the rate of interest of T-bills. Tco represents the commission costs incurred in an arbitrage transaction when a call option is overvalued; sell a call, buy a put, buy a futures contract, and borrow K at the rate of interest of T-bills.

In most cases, commission costs depend on the volume of the transaction. For this study, consider the minimum costs necessary to trade a single contract (ie size of 250). The commission costs were taken from an article published in CNNMoney.19 This article presents a schedule of the commissions charged by the most important discount brokers in the market (see Table 2). The bid-ask spread for futures contracts traded on the S&P 500 Index was estimated, sampling ve months of data from the CME (April 2001August 2001). For each date the magnitude of the closing bid-ask spread was recorded in relation to the closing price of the futures contract. Following this procedure, the authors determined that the average bid-ask spread was 0.09 per cent of the futures price, with a standard deviation of 0.04 per cent. This value was employed as the transaction cost associated with the bid-ask spread of any futures transaction. The data supplied by the CME do not contain any information pertaining to the bid-ask spread associated with put and call options on futures on the S&P 500 Index (http://www.cme.com). The authors estimated this bid-ask spread using information supplied by Yahoo Finance (http://www.yahoonance.com). A two-week sample was taken in which the bid-ask spread of those options closer to being at-the-money was

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Table 2: Commission costs charged by main brokers (CNNMoney)

Options Per contract ($) 0 0 0 0 0 0 1.75 1.60 0 0 Stocks Minimum ($) 29.95 14.95 12 25 8 5 20 7 14.95 15.21 Per contract ($) 0 0 0 0 0 0 0 0 0 0

Minimum ($) Charles Schwab E-Trade TD Waterhouse Fidelity Ameritrade Brown & Co (Chase) DLJ Direct Scottrade CyberBroker Arithmetic mean 35 29 28.13 27 29 25 35 20 19.95 27.56

recorded for each day. Although this approach yields only a rough estimation of bid-ask spreads, it constitutes the best approach the authors could have followed, given the lack of information. For call options the average bid-ask spread was 5.40 per cent of the price of the option, with a standard deviation of 2.31 per cent. For put options the average bid-ask spread was 4.99 per cent of the option price, with a standard deviation of 1.39 per cent. These values were considered to be the bid-ask spread-associated transaction costs applicable to transactions on call and put options on futures on the S&P 500 Index. For each trio of put, call and futures prices the test of the PCP relation was

carried out for the four different groups of studies that are presented below. Study 1 This study was done using the whole sample, with and without considering transaction costs. The authors considered: The number of times that the PCP relation was violated by the upper boundary. The number of times that the PCP relation was violated by the lower boundary, and the number of times that the relation was satised. Two values were eliminated from the sample because they were introducing a distortion factor to the sample, thus reducing the nal sample size to 245 days.

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 The average gain that could have been earned by an investor who took advantage of the arbitrage opportunities arising as a result of overvaluations or undervaluations in the prices of options. Study 2 Study 1 was repeated for the most liquid options contracts in each day, with and without transaction costs. Study 3 For all option contracts nearest to being at-the-money in each day, with and without transaction costs, the authors: Computed the percentage deviation of the theoretical price in relation to the maximum/minimum price determined by the PCP relation. Computed a descriptive statistic of the percentage deviation of the theoretical price between 2nd January, 2001 and 31st December, 2001. Two values were eliminated from the sample because they were introducing a factor of distortion to the sample, thus reducing the nal sample size to 245 days. Drew a graph of the daily deviation of the theoretical price from 2nd January, 2001 to 31st December, 2001. Study 4 Study 3 was repeated for the most liquid options contracts in each day, with and without transaction costs.

EMPIRICAL RESULTS This section presents the results obtained from each of the four studies. Study 1: Determination of the number of violations of the PCP relation for the whole sample In this study the authors calculated from the data (put prices, futures price contracts, interest rates, exercise prices, expiration dates), the rank within which the theoretical price of a call option should have oscillated. The observed closing price of a call was then compared with the obtained theoretical rank. When the observed price surpassed the upper boundary of the rank, it was classied as a violation of the upper boundary. When the violation occurred below the lower boundary, it was classied as a violation of the lower boundary. When the call price observed was within the rank it was classied as a non-violation of the PCP relation. This study was rst made without including transaction costs (model 1) and was later repeated adding transaction costs (model 2). Additionally, the authors computed the theoretical arbitrage gain an investor could have obtained in each one of the cases should he/she have detected the violation of the PCP relation (see Table 3).
Analysis of study 1

Of the total of samples that include in-the-money, out-of-the-money and at-the-money options, it can be observed that when transaction costs are not included

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Table 3: Study 1 Violations of the PCP relation for the whole sample
Excluding transaction costs (model 1) Sample size Violation upper boundary Violation lower boundary Non-violations Total Gain (Arbitrage) 508 1,056 1,207 2,771 $1,591 % 18.33 38.11 43.56 Including transaction costs (model 2) Sample size 223 448 2,100 2,771 $974 % 8.05 16.17 75.78

the PCP relation holds in only 43.56 per cent of the cases (see Table 3). The greater number of violations of the relation occur by the lower boundary (38.11 per cent). These violations can be attributed to the fact that transaction costs are being ignored in model 1 and to the low liquidity levels of some of the instruments considered in the sample (this may contribute to the distortion since the data being used is non-synchronous). This problem can be important especially for those options contracts that are deep in-the-money and deep out-of-the-money. When the study was repeated using model 2, that is, including transaction costs, the number of non-violations increases to 75.78 per cent, compared to 43.56 per cent in model 1. Most of the violations still occur in the lower boundary, although diminishing to 16.17 per cent. It can be observed that the inclusion of transaction

costs in the model causes the PCP relation to be fullled a larger number of times. Nevertheless, according to this study, arbitrage opportunities are still present in 28 per cent of the cases. When calculating the gains that an investor could have potentially obtained when engaging in arbitrage transactions, it can be observed that, in the case in which transaction costs are not included in the model, the average gain is $1,591 for each contract of 250, whereas in the case when transaction costs are included, the gain diminishes to $974. Study 2: Determination of the number of violations of the PCP relation for options that are the nearest to being at-the-money and for options that present greater liquidity This study is similar to study 1, with the difference that, in this case, in the rst part

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Table 4: Study 2A Violations of the PCP relation for at-the-money contracts

Excluding transaction costs (model 1) Sample size Upper boundary violation Lower boundary violation Non-violations Total Gain (Arbitrage) 37 49 161 247 $862 % 14.98 19.84 65.18 Including transaction costs (model 2) Sample size 13 15 219 247 $460 % 5.26 6.07 88.66

only those options that are the nearest to being at-the-money every day are used (see Table 4) and, in the second part, the most liquid options every day (largest volume) are employed (see Table 5). This is done with the purpose of isolating the impact that including in the sample instruments that could be less liquid can have, and that could, therefore, cause distortions because of the use of non-synchronous data.20
Analysis of study 2

Of the total of samples that include only options that are the closest to being at-the-money it can be observed that, when transaction costs are considered, the PCP relation is fullled in 65 per cent of cases (see Table 4). This represents an increase of 22 points in relation to the previous result in which all the options were included. Also, for options with the greatest volume of transactions every day it

can be observed that, when transaction costs are not included, the relation holds in 51.42 per cent of the cases (see Table 5). This represents a 9 per cent increase in the fulllment of the PCP relation compared to study 1. Both results are an indication that the liquidity factor inuences the results of the study. The greater number of violations of the PCP relation happens by the lower boundary in all of the cases. This result is consistent with the results obtained in study 1. The violations can still be attributed to the transaction costs that are ignored in model 1. When transaction costs are included in the study, according to model 2, it can be observed that, for the subgroup of options that are the nearest to being at-the-money as well as for the case of the most liquid option contracts, the number of times that the PCP relation is satised increases to 87 per cent (options

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Table 5: Study 2B Violations of the PCP relation for the most liquid option contracts
Excluding transaction costs (model 1) Sample size Upper boundary violation Lower boundary violation Non-violations Total Gain (Arbitrage) 20 90 127 247 $1,485 % 12.15 36.44 51.42 Excluding transaction costs (model 2) Sample size 10 25 212 247 $653 % 4.05 10.12 85.83

at-the-money) and 86 per cent (options with the largest traded volume) respectively. These numbers represent a substantial increase in relation to model 1 (in which transaction costs were not considered) and in relation to the same scenario in study 1, in which all the operations were included (both liquid and illiquid). The results of this study, compared with the previous investigations of Loudon15 and Cusack7 in Australia, are different in the sense that the number of violations of the upper boundary of the PCP relation is greater than the number of violations of the lower boundary in these studies. This can have several causes, such as: the costs of transactions in the Australian market differ from the costs of transactions at the CME, partly because the Australian market is substantially less liquid than the CME. The studies of Loudon15 and Cusack7 were made on options on stocks, whereas the

present study is made on options of futures on the S&P 500 Index. These instruments have different liquidity patterns and transaction costs. When calculating the gains that an investor could have obtained when engaging in arbitrage transactions it can be observed that, in the case of options that are the nearest to being at-the-money (and excluding transaction costs from the model), the average gain is $862 for each contract of 250. In the case where transaction costs are included, the gain diminishes to $460. In the case of more liquid options these values are $1,485 (with transaction costs) and $653 (without transaction costs). In all cases it can be considered that these amounts are not economically signicant, especially because other factors exist (taxes, for example) that could reduce further the margin of gain with zero investment.

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In order to measure the percentage economic signicance of the violations, the percentage of deviation for each one of the samples of options that are the nearest to being at-the-money are calculated in the following study. Study 3: Magnitude of violations of the PCP relation for options that are the nearest to being at-the-money In this study, the price obtained in the upper boundary (PUL) and the price obtained in the lower boundary (PLL) are compared (in percentage terms) with the observed value of the closing price of the call (PT). This comparison is made using the following procedure:

average and the median deviation of the theoretical price with respect to the real price. This is done with the purpose of identifying the percentage deviation that better represents the sample. Figures 1, 2 and 3 illustrate the ndings.
Analysis of study 3

Deviation

PT < PLL

PT PLL PT

PLL PT PLU 0 PT > PLU PT PLU PT

This procedure can be used to determine the magnitude by which the price of those options contracts that are the nearest to being at-the-money deviate from the theoretical price range with the purpose of determining if the price deviation is economically signicant. Each day the authors analysed the option contract that was the nearest to being at-the-money, resulting in a total of 245 samples. For these 245 samples, statistical calculations were made to determine the

For contracts that are closest to being at-the-money it can be observed that, on average, when transaction costs are not included, the percentage deviation is around 7 per cent with a median of 4.5 per cent (see Figure 1). For the majority of the samples (192 of 245) the deviation is in the interval between 0 per cent and 7.14 per cent, with a midpoint of 3.57 per cent. Similarly, when transaction costs are included, the average percentage deviation is 3.0 per cent with a median of 1.96 per cent (see Figure 2). For 225 of the 245 samples the deviation is in the interval between 0 per cent and 3.6 per cent with a midpoint of 1.8 per cent. In Figure 3, it can be observed that only 15 samples of 245 seem to turn aside from the average pattern. This deviation could be a consequence of the use of non-synchronous data, or it could be due to some specic events in the stock market that generated information asymmetries. Through this study it can be corroborated that the introduction of transaction costs into the PCP relation diminishes the number of violations and the

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Figure 1: Observed versus theoretical percentage price deviation for all at-the-money contracts ignoring transaction costs
250
Percentage deviation

200 150 100 50 0 3.57 10.71 17.86 25.00 32.14 Class rank 39.29 46.43 53.57 60.71

Notes: mean: 7.27%; standard deviation: 5.80%; median: 4.56%; median deviation: 4.26%

Figure 2: Observed versus theoretical percentage price deviation for all at-the-money contracts including transaction costs
250 Percentage deviation 200 150 100 50 0 1.80 5.39 8.99 12.59 16.18 Class rank 19.78 23.38 26.97 30.57

Notes: mean: 3.02%; standard deviation: 2.24%; median: 1.96%; median deviation: 1.35%

percentage deviation by an important magnitude, as well as the percentage magnitude of the violation with relation to

the price. The 3 per cent deviation of the observed price with respect to the theoretical price of the option for the cases

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Figure 3: Observed versus theoretical percentage price deviation for all at-the-money contracts with and without transaction costs
70 60 Percentage deviation 50 40 30 20 10 0
7/ 01 6/ 01 8/ 01 9/ 01 01 01 01 1/ /1 02 02 /1 01 01 2/ 01 5/ 01 4/ 1/ 3/ /0 /0 /0 /0 /0 /0 /0 /0 /0 02 /1 0/ 2/ 01

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in which violations occur in the model (approximately 11 per cent) can be attributed to the use of non-synchronous data in the study, the fact that taxes were not included, the variability of the costs of transaction depending on the contract and the commissions charged by brokers. Study 4: Magnitude of violations of the PCP relation for options possessing the largest volume of trades This study is similar to study 3, with the difference that it is based on options that exhibit the largest liquidity every day (largest traded volume). Figures 4, 5 and 6 show the results obtained.

Analysis of study 4

For contracts with the largest liquidity, when transaction costs are not included it can be observed that the average percentage deviation is around 22 per cent, with a median of 10 per cent (see Figure 4). For the majority of the samples (179 of 245) the deviation is in the interval of 0 per cent and 13.76 per cent, with a midpoint of 6.88 per cent. Similarly, when transaction costs are included, the average percentage deviation is 10.21 per cent with a median of 7.68 per cent (see Figure 5). For 226 of the 245 samples the deviation is in the interval between 0 per cent and 14.17 per cent, with a midpoint of 7.08 per

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Figure 4: Observed versus theoretical percentage price deviation including all contracts possessing the largest volume and ignoring transaction costs
210 Percentage deviation 180 150 120 90 60 30 0 6.88 20.64 34.40 48.16 61.92 Class rank 75.68 89.44 103.20 116.96

Notes: mean: 21.93%; standard deviation: 22.19%; median: 9.42%; median deviation: 16.22%

cent. In Figure 6, it can be observed how the introduction of transaction costs diminishes the number of violations. Through this study it can be once again corroborated that the introduction of transaction costs into the PCP model substantially diminishes both the number of times that the relation is violated and the percentage magnitude of the violation in relation to the price. Nevertheless, this study shows values that are higher than those shown in study 3, which leads the authors to think that the best way to diminish the noisy effect of using non-synchronous data in the samples is to consider options that are the nearest to being at-the-money instead of those that present the greatest traded volume on each day. Apparently, a greater relation of synchrony (or simultaneity between

purchases and sales of puts, calls and futures contracts) between the samples of options is present when we analyse at-the-money contracts.

SUMMARY Results obtained in the determination of the pattern of violations of the PCP relation using options on futures on the S&P 500 Index demonstrate that the inclusion of transaction costs in the model considerably reduces both the number of times that a violation occurs and the magnitude of the distortion. Similarly, the authors have veried in this study that when transaction costs are included in the model, arbitrage opportunities are translated in the possibility of a gain well below $1,000 for an option contract on futures on

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Figure 5: Observed versus theoretical percentage price deviation including all contracts possessing the largest volume and including transaction costs
250 Percentage deviation 200 150 100 50 0 7.08 21.25 34.42 49.59 63.76 Class rank 77.93 92.10 106.26 120.43

Notes: mean: 10.21%; standard deviation: 5.76%; median: 7.68%; median deviation: 3.63%

Figure 6: Observed versus theoretical percentage price deviation including all contracts possessing the greatest volume with and without transaction costs
180 160 Percentage deviation 140 120 100 80 60 40 20 0
02 /0 02 /0 02 /0 02 /1 02 /1 2 /1 1/ 01 02 01 /0 02 /0 03 /0 04 /0 05 /0 7/ 0 8/ 0 06 /0 9/ 0 0/ 0 /0 1 1 1 1 1 1 1 1 1 1 1

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the S&P 500. This amount does not represent an economically signicant value, especially if it is noted that other factors, such as taxes, have not been considered in this model. These results offer support to the efcient market theory and can be appraised through Tables 6 and 7. The average deviation of the observed price of an American option call compared to the calculated theoretical interval oscillates between 0 per cent and 7 per cent when Mertons PCP relation for American options excluding transaction costs is used. Considering only those options contracts that are the nearest to being at-the-money, and including transaction costs in the model, it can be observed that the average deviation diminishes to 3 per cent. This 3 per cent can be caused by estimation errors in the bid-ask spread, estimation errors in commission costs, taxes, and the fact that options on futures on the S&P 500 Index are American. It could be stated that the PCP relation applies more accurately for options that are the nearest to being at-the-money. When deep out-of-the-money or deep in-the-money options were used in the tests the number of violations increased. This may be the result of the low liquidity levels of these contracts. The authors also veried that options with the largest volumes of trades introduced a percentage of violations in the study (in absolute and percentage amount of deviation) slightly

higher than those found in the study in which options were the nearest to being at-the-money. This nding demonstrates that there is more synchrony in samples where options are nearer to being at-the-money than in the case where options presented the largest volume. The pattern of violations of the PCP relation is opposed to that found by Cusack7 and Loudon14 for the case of the Australian market, in the sense that the largest percentage of violations occurred by the lower boundary (upper in the case of the Australian studies, which are based on determining the rank of prices of put options). The reasons for this can be diverse. For example, differences between transaction costs that apply in the Australian and the American markets, or the fact that the studies in Australia were made on stock options, whereas the authors study was based on options on futures. Nevertheless, in both studies the introduction of transaction costs in the model considerably diminishes the number of non-violations. Finally, it was observed that the market reacts to distort the theoretical prices of call when certain events follow one another. For instance, it was veried that for all at-the-money contracts there appears to be a strong distortion of prices between the months of March and May. These distortions cannot be explained by transaction costs or by the presence of non-synchronous trades since the pattern was consistent for all contracts. These distortions could have been

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Table 6: Summary number of violations of the PCP relation

Without transaction costs (TCs) (model 1) Whole sample Upper boundary violation (%) Lower boundary violation (%) Non-violations (%) Gain (Arbitrage) 18.33 38.11 Nearest to being Most at-the-money liquid 14.98 19.84 12.15 36.44 Whole sample 8.05 16.17 With transaction costs (TCs) (model 2) Nearest to being Most at-the-money liquid 5.26 6.07 88.66 $460 4.05 10.12 85.83 $653

43.56 65.18 $1,591 $862

51.42 75.78 $1,485 $974

Table 7: Summary magnitude of the PCP violation

At-the-money Without TC With TC Mean (%) Standard Dev (%) Median (%) Median Dev (%) 7.27 5.80 4.56 4.26 3.02 2.24 1.96 1.35 Most liquid Without TC With TC 21.93 22.19 9.42 16.22 10.21 5.76 7.68 3.63

caused by information asymmetries that translate in arbitrage opportunities seen during certain periods of time and could be economically signicant. References
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