Options: Risk Reducing or Creating?

Abstract

The question connected with the main function of options, i.e. risk hedging, alternatively raises a contradictory version of the question, i.e. creating risk. These pieces of question statement are connected with the investigation of effectiveness of the derivative market and in particular the mechanisms of option pricing. The Russian option market is presented by the only one segment of Russian Trading System called Futures and Options on RTS – FORTS. In this paper we propose a method to calculate options fair prices based on risk-neutral pricing and show the degree of market effectiveness in the sense of whether the arbitrage opportunities tend to drive the market to an arbitrage-free equilibrium or not. The dynamics of the underlying assets’ log returns is described as an infinitely divisible Levy processes and mean-correcting Monte-Carlo simulation of risk-neutral market trajectories is applied to calculate option fair prices. An empirical study of more than 250 future options on AO Gazprom and AO Sberbank stocks and the RTS Index is realized. Results show a systematical ineffectiveness of the Russian option market in the sense that option prices allow long running arbitrage with no demand reaction, leading to price adjustment as would be expected.