RESEARCH Testing Lower Boundary Conditions

includes research articles that

for Index Options Using Futures
Prices: Evidences from the Indian
focus on the analysis and
resolution of managerial and
academic issues based on
analytical and empirical or case
research Options Market
Alok Dixit, Surendra S Yadav and P K Jain

Executive Options are the contracts which serve as a tool for risk hedging, price discovery, and
better allocation of capital. The efficiency of an options market, i.e., the correctness of
Summary option prices denotes that it is working well at its well-identified functions (Ackert
and Tian, 2000). In view of this, the efficiency of options market has been of equal
interest to the academics as well as practitioners and a number of studies on efficiency
of options market have been carried out across the globe in different options markets.

The present paper attempts to assess the pricing efficiency of the S&P CNX Nifty index
options in India by testing the Lower Boundary Conditions (LBCs) using futures prices
instead of spot values. The methodology adopted essentially tests a joint market effi-
ciency hypothesis of index options and index futures. This has been done in view of
the fact that the use of futures markets helps in doing away with the short-selling
constraint as futures can easily be shorted. And, it becomes a natural choice for analy-
sis as the short-selling has been banned in the Indian securities market during the
period under reference. Moreover, the use of futures markets, to a marked extent, helps
in ensuring the exploitability of arbitrage opportunities when underlying asset is an
index.

The study covers a period of six years from June 4, 2001 (starting date for index options
in India) to June 30, 2007. The major findings of the study are:

• The put options market is more efficient than the call options market, given the
existing market microstructure in India during the period under reference.
• Another equally important finding is that the put options market showed an im-
provement in the pricing efficiency over the years whereas the call options market
demonstrated a counterintuitive and adverse development.
• However, the profit potential offered by highly traded opportunities both in the
cases of call and put options seems to be unexploitable in the presence of transac-
tion costs.
• Moreover, the dearth of liquidity in the case of otherwise exploitable opportunities
which carry higher profit potentials has been the main inhibiting factor to
KEY WORDS arbitrageurs.

Arbitrage Profits Therefore, in short, it is reasonable to conclude that majority of violations in call as
well as put options could not be exploited on account of the existing market-micro-
Ex-post Analysis structure in India during the period under reference (especially short-selling con-
Market Efficiency straint that caused underpricing in futures to persist) and the dearth of liquidity in the
options market. In other words, the revealed state of options pricing can be designated
Options Market to the short-selling constraints and dearth of liquidity.

VIKALPA • VOLUME 36 • NO 1 • JANUARY - MARCH 2011 15

T
he options markets play a central role in an
economy in view of the fact that they enhance
better allocation of capital in securities market by
virtue of their functions, namely, risk hedging and price
discovery. In today’s parlance where the demand for the
structured financial products (which require excessive
use of options contracts) is booming in India, the role of
such markets has acquired greater significance. The ‘open
interests’ in the options segment of the Indian derivatives
market has even surpassed that of the futures market for
the last few months since April, 2008. This development
has put the Indian derivatives market at an equal footing
with the other international (developed) markets where
the options are preferred to futures. There could be two
major reasons for such a development. Firstly, increase in
the portfolio management services (PMS) which provide
structured financial products (using options market) to
high profile investors. Secondly, there has taken place an
increase in the variety of the products (in terms of matu-
rity period) on account of the introduction of long-dated
options on March 03, 2008. These options enable an in-
vestor to take a position up to five years.
Considering the increasing importance of the options
market in India, it is desired that the market should carry
out its required functions in the best possible way. For the
purpose, it is imperative that the market should be effi-
cient. The reason is that well-functioning options mar-
kets are vital to a thriving economy as these markets
facilitate price discovery, risk hedging, and allocation of
capital to its most productive uses. Inefficiency of a finan-
cial market (e.g., options market in this paper) indicates
that it is not performing the best possible job at the above-
mentioned important functions (Ackert and Tian, 2000).
The present paper attempts to assess the pricing efficiency
of the index options in India using the futures contracts
on the same underlying asset, i.e., S&P CNX Nifty index.
The use of futures markets helps, to a marked extent, in
ensuring the exploitability of arbitrage opportunities
when the underlying asset is an index. Moreover, the use
of futures markets helps in doing away with the short-
selling constraint as a futures can easily be shorted. No-
tably, the use of futures prices on the same underlying
asset instead of spot prices essentially makes this ap-
proach a test of joint market efficiency, as opined by Fung,
Cheng and Chan (1997). At the same time, the use of fu-
tures prices facilitates in assessing the degree of integra-
tion or pricing interrelationships between the different
16 TESTING LOWER BOUNDARY CONDITIONS FOR THE S&P CNX NIFTY INDEX OPTIONS ...
derivative instruments being traded in the market (Lee
and Nayar, 1993). In other words, this approach helps in
addressing the question whether market participants con-
sider important pricing interrelationships while pricing the
index options. The scope of the present study is confined
to the pricing interrelationship between index options
and index futures.
The use of futures prices, however, puts one restriction
on the otherwise model-free approach, i.e., it assumes cost-
of-carry model to hold. Therefore, this approach cannot
be designated as ‘model-free’ unlike the test of the bound-
ary condition using spot prices. However, the approach
still remains less restrictive compared to those based on
certain pricing models, e.g., those based on Black-Scholes
model (1973) which assumes that the stock price and vola-
tility are governed by some stochastic processes.
The violations or mispricing signals observed from the
test procedures have been classified as per ‘liquidity with
three specified levels’ and ‘maturity with four specified levels’.
Also, the violations so classified as per the specified lev-
els of maturity have further been sub-classified as per the
three specified levels of liquidity. The classification fa-
cilitates a meaningful explanation to the exploitability of
such violations and, therefore, is very crucial in assess-
ing the efficiency of the market. This has been done in
view of the fact that mere presence of violations does not
indicate market inefficiency; it is the unexploitability and
persistence of such violations which pose serious con-
cerns/threats to the market efficiency.
Moreover, the learning behaviour of the investors in op-
tions markets has also been examined. This has been done
by analysing the number of violations vis-à-vis the num-
ber of observations analysed over the years under refer-
ence for both the call and put options. The learning
hypothesis, which requires that the number of violations
should go down over the years, has been proposed to
gauge the developments related to the efficiency of the
market. The analysis of violations over the years under
reference is in line with Mittnik and Rieken (2000), a study
done in German stock index options market.
The findings of this research paper might be useful to
brokerage houses, institutional investors --domestic as
well as foreign, the National Stock Exchange (NSE), and
the Securities and Exchange Board of India (SEBI); these
findings are likely to be equally significant to the aca-
demics.
THE BOUNDARY CONDITION
This section discusses lower boundary conditions using
futures prices. The lower boundary conditions, first pro-
posed by Merton (1973) and further extended by Galai
(1978), play a crucial role in assessing the options market
efficiency. A number of research studies have been car-
ried out in different options markets using the lower
boundary conditions to assess the efficiency of the mar-
kets including the first one by Galai (1978). The other
studies which tried to diagnose the options market effi-
ciency based on the violation of lower boundary condi-
tions include Bhattacharya (1983), Halpern and Turnbull
(1985), Shastri and Tandon (1985), Chance (1988),
Puttonen (1993a), Berg, Brevik and Saettem (1996), Ackert
and Tian (2001), Mittnik and Rieken (2000), Dixit, Yadav
and Jain (2009).
The lower boundary conditions of option prices denote
the minimum price of an options contract at a given point
of time during the life of an options contract. The viola-
tion of the condition indicates arbitrage opportunities.
Therefore, the price for an options contract should neces-
sarily be equal to or higher than that suggested by the
lower boundary conditions. In order to ensure the correct
pricing in an options market, this is a necessary condi-
tion which needs to be satisfied to uphold the well-known
no-arbitrage argument of options pricing. In literature,
the lower boundary conditions have been defined for the
European options as well as American options. In this
paper, as we are analysing the S&P CNX Nifty Index op-
tions which are European (that can be exercised only at
maturity) in nature; the condition defined for European
options constitutes the basis of the study.
The method applied to test the efficiency of the options
market is in line with other studies conducted in different
markets for the same purpose with only one difference,
i.e., use of the futures prices of the same underlying asset
instead of its spot prices. The test of Lower Boundary
Conditions using futures prices is in line with Puttonen
(1993a), a study done in the Finnish index options mar-
ket. Moreover, the test of options market efficiency using
futures prices (on the same underlying asset) is in line
with Lee and Nayar (1993), Fung and Chan (1994), Fung,
Cheng and Chan (1997), Fung and Fung (1997), Fung
and Mok (2001), etc., with the only difference that the
condition tested in the paper is the lower boundary con-
ditions for the option prices whereas all the above stud-
VIKALPA • VOLUME 36 • NO 1 • JANUARY - MARCH 2011
ies focus on the put-call-futures parity condition.
The lower boundary conditions using corresponding fu-
tures prices (with the same maturity date) are given in the
equations (1) and (2) for the call and put options respec-
tively. These conditions are expected to hold in an effi-
cient options market. Though the transaction costs have
not been incorporated in the equations (1) and (2), the
results have been interpreted considering the estimate of
transaction costs discussed in the data section.
(1)
(2)
In the above equations,
Ct = market price of a call option at time t,
Pt = market price of a put option at time t,
Ft = value of the S&P CNX Nifty futures (with same
expiration date as of the options under consider-
ation) at time t,
K = strike price of the options contract,
T = expiration time of the options contract at the time
when it was floated,
r = continuously compounded annual risk-free rate
of return,
(T-t) = time to maturity of the options contract at time t
(measured in years).
The dividends expected from the underlying asset dur-
ing the life of the option have been ignored since the un-
derlying asset used in the test is futures prices/value of
the index instead of the spot prices/value. This has been
done in view of the fact that the futures prices (in an effi-
cient market) are expected to have impounded the effect
of dividends on the prices of the underlying asset.
In short, the use of futures prices essentially tests the joint
hypothesis of the market efficiency of futures as well as
options contracts in India.
Testable Form of the Lower Boundary Conditions
The equations (1) and (2) have been rearranged in order
to make them testable to gauge the efficiency of the op-
tions market. The testable form, to gauge the Efficient
Market Hypothesis (EMH) using lower boundary condi-
tions, is given in the equations (3) and (4) for call and put
options respectively.
17
 (3)
(4)
In the above equations, and denote the absolute
amount of abnormal profits (ex-post) or mispricing sig-
nals from call and put options respectively, if the viola-
tion of lower boundary condition occurs. A violation of
the lower boundary condition is recorded if >0 and
>0 for call and put options respectively. Though the
presence of such profits is only indicative of market inef-
ficiency, it should not be treated as a conclusive remark
on the efficiency of the market.
The equations (3) and (4) have been specified assuming
no transaction costs and zero or negligible bid-ask spread.
It may be noted that there is always a chance that the
arbitrage opportunities suggested by these equations may
disappear in the presence of transaction costs and the
bid-ask spread. Therefore, the violations have been inter-
preted considering the transaction costs and bid-ask
spreads. In this regard, an attempt has been made to esti-
mate the transaction costs. The details are summarized
in the data section. On the contrary, given the fact that the
bid-ask spread for options is not included in the transac-
tion database provided by NSE and the difficulty to esti-
mate such costs, it has been excluded in the above
equations. In operational terms, our study is in line with
that of Halpern and Turnbull (1985).
In addition to this, commenting upon the exploitability of
observed mispricing signals, Trippi (1977), and Chiras
and Manaster (1978) concluded that the signals so ob-
served were exploitable using a specified trading strat-
egy to ensure ex-ante exploitation of such profit
opportunities. However, in the present study, no strategy
has been specified to ensure ex-ante exploitability of ab-
normal profits suggested by mispricing signals as the test
procedure applied is ex-post in nature.
Normalization of Abnormal Profits
In order to facilitate comparison across different levels of
liquidity, maturity, and time-period (years) under refer-
ence, the amount of absolute abnormal profits has been
normalized to the ‘strike price plus premium’. That is,
in the case of call options and for
put options. The normalization criterion is in line with
Nilsson (2008) since it has used strike price as a normal-
ization parameter. Also, the normalization procedure is
18 TESTING LOWER BOUNDARY CONDITIONS FOR THE S&P CNX NIFTY INDEX OPTIONS ...
similar to the one used by Kamara and Miller Jr. (1995)
since their results are more or less identical with those
documented by Nilsson (2008) in this regard using strike
prices as a normalization criterion. In the present study,
the ‘strike price plus premium’ has been used as a normal-
ization criterion as it forms the basis of charging broker-
age (which is a major constituent of the transaction costs
in the Indian derivatives market). Therefore, this proce-
dure facilitates a direct comparison of the violations (in
percentage terms) vis-à-vis transaction costs and, thus,
helps in assessing the exploitability of the mispricing sig-
nals in the presence of transaction costs.
DATA
Options, Futures and Interest Rates
The data considered for the analysis can be broadly clas-
sified into three categories, namely, (i) data related to S&P
CNX Nifty index options contracts, (ii) data related to the
futures contracts, i.e., the S&P CNX Nifty index futures
and (iii) data on the risk-free rate of return. The data on
the options consist of daily closing prices of options, strike
prices, deal dates, maturity dates, and number of con-
tracts traded of call and put options respectively. In order
to minimize the bias associated with nonsynchronous trad-
ing1, only liquid option quotations2 are being considered
for the analysis. The second data set is regarding the fu-
tures contracts. It includes daily closing prices of S&P
CNX Nifty index futures, deal dates, maturity dates and
number of contracts traded. The third data set consists of
monthly average yield on 91-days Treasury-bills. The yield
on T-bills has been converted into continuously com-
pounded annual rate of return using the relationship
given in equation 5.
(5)
Where, r = Proxy for continuously compounded annual
risk-free rate of return, r = Average annual yield on 91-
days T-bill of the maturity corresponding to the maturity
1 Nonsynchronous trading refers to the phenomenon of different
timings of closing transactions in the two markets (i.e., the options
market and the underlying’s market in this case).
2 In the study, the liquid options quotations have been defined as
those quotations which have at least one contract traded. Though
the definition of liquid contracts is not useful in ensuring exploitability
of arbitrage opportunities on account of the high bid-ask spread for
such options, this has been done in order to gauge the total number
of violations in Indian options market. Moreover, while ensuring
the exploitability of the arbitrage opportunities, due consideration
has been given to the liquidity.
date of the options contract.
Notably, the data on index futures has been matched with
the corresponding options contracts on the basis of two
criteria, viz., (a) deal date and (b) the expiration date of
the options contract.
The data for all the three mentioned categories have been
collected from June 4, 2001 (starting date for index op-
tions in Indian securities market) to June 30, 2007. The
first and second data sets have been collected from the
website of NSE and the third category of data set has been
collected from the website of the Reserve Bank of India
(RBI).
Transaction Costs
Transaction costs typically include brokerage charged by
the brokerage houses/trading members of the exchanges,
service tax on the brokerage, stamp duty, opportunity cost
of the margin deposits required in the case of futures con-
tracts and short options positions, etc. In the Indian capi-
tal market, another charge, namely, Securities
Transactions Tax (STT) was introduced and implemented
with effect from October 1, 2004. Notably, such charges
were to be levied only on the sell side of the transactions
in the derivatives market unlike the equity market trans-
actions where STT was proposed to be levied on both legs
of the transactions. In short, the transaction costs being
considered in the study typically include brokerage, ser-
vice tax on the brokerage, and STT (October 1, 2004 on-
wards).
Since the transaction costs constitute a major constraint
to arbitrage (Ofek, Richardson and Whitelaw, 2004), an
attempt has been made to have an estimate of such costs
in Indian derivatives market. For the purpose, interviews
were conducted with the senior employees of brokerage
houses based at Delhi, India. This has been done in view
of the fact that the trading member organizations (broker-
age houses) are the best source of information in this re-
gard as they themselves deal in the market and facilitate
trading in F&O as well as cash market for different types
of investors. Therefore, it would be reasonable to use the
feedback of trading member organizations in this regard.
Moreover, it may be noted that some of the studies on F&O
segment (e.g., Vipul, 2008, a study in the Indian context)
have estimated the transaction costs on the same lines.
Based on the responses from the trading member firms, a
consensus was arrived at an estimate of brokerage, viz.,
VIKALPA • VOLUME 36 • NO 1 • JANUARY - MARCH 2011
0.05 per cent (including service taxes) of ‘(strike price +
premium)*lot size’ for options contracts and ‘Futures price
at the time of the transaction*lot size’ for futures con-
tracts in the case of retail investors throughout the period
under reference. However, such costs may go down up to
0.03 per cent (including service taxes) for the institutional
investors. Notably, the brokerage houses bear the least
cost of trading amongst all types of investors/players in
the market as they are not required to pay any brokerage.
However, it would be reasonable to consider the oppor-
tunity cost for the brokerage house and a logical estimate
could be the cost incurred by the institutional investors,
i.e., 0.03 per cent as pointed out by Vipul (2008).
Moreover, the STT charge of 0.01 per cent (on the sales
side of the transactions in derivatives market) has also
been considered while interpreting the results over the
years. Since the STT was introduced in October 1, 2004, it
has been considered as part of the transaction costs for
the arbitrage opportunities which occurred after October
2004, i.e., in years 2004-05, 2005-06, and 2006-07 in the
present study. Therefore, for the analysis purpose, the
major constituents of the transaction costs have been the
brokerage and the service tax on it before October 1, 2004
and it additionally includes STT on the sales side of the
transactions thereafter. The definition of the transaction
costs has been confined to the brokerage and STT (wher-
ever applicable) as these constitute, in general, more than
90 per cent of the transaction costs (excluding bid-ask
spread). Though the analysis has been conducted ignor-
ing the bid-ask spread and opportunity cost of the mar-
gin deposits, these have been given due consideration
while ensuring the exploitability of mispricing signal.
This has been done in view of the fact that bid-ask spread,
in particular, plays a very important role in assessing the
options market efficiency, as opined by Baesel, Shows
and Thorpe (1983) and Phillips and Smith (1980).
Before adding the transaction costs of options and fu-
tures contracts in order to arrive at the transaction costs
for the arbitrage strategy, it becomes necessary to calcu-
late them on the same basis, i.e., (K+C) for call options
and (K+P) for put options. This is required in view of the
fact that the mispricing signals have been normalized to
these criteria. And, therefore, it would facilitate a fair and
direct comparison of mispricing signals and transaction
costs. Since the transaction costs in the case of options
are based on ‘(strike price + premium)’ and ‘futures price’
forms the basis for the transaction costs in the case of
19
futures contracts, the transactions costs of futures con-
tracts has to be seen in relation to the ‘(strike price + pre-
mium)’ to ensure the uniformity of basis for transaction
costs and normalization of violations. In this regard, the
transaction costs on the futures prices (0.05*Futures price)
have been normalized to ‘strike price+ premium’. Empiri-
cally, it was found that the amount of transaction cost on
futures when normalized to ‘strike price+ premium’ re-
mained intact at the level of 0.05 and 0.03 per cent on an
average in the case of call options for the retail and insti-
tutional investors/trading members respectively; it turned
out to be 0.043 and 0.026 per cent in the case of put op-
tions. Therefore, the transaction costs of futures (which
should be added to that of options’ in order to arrive at
the total transaction costs) are 0.05 per cent and 0.043 per
cent in the cases of call and put options respectively for
retail investors; such costs are 0.03 per cent and 0.026 per
cent for institutional investors/trading member organi-
zations.
The transaction costs applicable in the case of a short
hedged position, needed to exploit the mispricing indicated
by a call option, was estimated at 0.10 per cent before
October, 2004 and 0.11 per cent thereafter. In this case,
the arbitrageur needs to buy the call option and sell a
futures on the same underlying asset. In short, the trans-
action cost considered in the paper is 0.10 (0.05+0.05) per
cent prior to October 1, 2004 and 0.11(including STT of
0.01 per cent) thereafter for the retail investors. Likewise,
in the case of a put option, there is a need to create a long-
hedged position, i.e., to buy the underpriced put option
and take a long position in the futures contract on the
same underlying asset. In this case, the applicable trans-
action costs would be 0.093 (0.05+0.043) for the whole
period under reference and no STT needs to be included
as it is levied on the sales side of a transaction. However,
for the trading member firms and institutional investors,
it would be 0.06 per cent before October 1, 2004 and 0.07
(including STT of 0.01 per cent) thereafter for call options,
and 0.056 (0.03+0.026) per cent for put options through-
out the period under reference.
ANALYSIS AND EMPIRICAL RESULTS
Magnitude of the Violations
In order to have better insights about the behaviour of the
mispricing signals obtained from the lower boundary
conditions, the violations have been examined with re-
spect to liquidity and maturity. In addition to this, both
20 TESTING LOWER BOUNDARY CONDITIONS FOR THE S&P CNX NIFTY INDEX OPTIONS ...
the parameters have further been classified into specified
levels. Liquidity of the options has been decomposed into
three levels based on the trading volume, namely, (i) thinly
traded, options which have 1 to 100 contracts traded per
day; (ii) moderately traded, options which have 101 to
500 contracts traded per day; and (iii) highly traded, op-
tions which have more than 500 contracts traded per day.
Likewise, maturity of the options has been classified into
four levels, namely, (i) ‘0-7’ days to maturity; (ii) ‘8-30’
days to maturity; (iii) ‘31-60’ days to maturity; and (iv)
‘61-90’ days to maturity.
Also, the violations so classified as per the specified lev-
els of maturity have further been sub-classified as per the
three specified levels of liquidity in view of the fact that
liquidity constitutes the basis for exploitation of arbitrage
opportunities. The proposed classifications and their sub-
classifications enable us to draw some meaningful infer-
ences about the exploitability of the observed mispricing
signals which, in turn, help to assess the role of the exist-
ing market-microstructure in facilitating market efficiency
in the Indian derivative market. The results related to vio-
lations, classified as per the specified levels of liquidity
and maturity along with their sub-classifications, are
summarized in Tables 1 and 2 respectively.
Notably, the results across the specified levels of liquid-
ity have direct implications for the exploitability of the
observed mispricing signals as the higher the liquidity is,
the lower would be the trading cost and bid-ask spread.
Also, the higher liquidity ensures execution of the trad-
ing strategy required to tap such abnormal profit poten-
tials. In contrast, the different specified levels of maturity
have an indirect impact since these primarily influence
the liquidity and, hence, the exploitability of such viola-
tions. And, therefore, the behaviour of violations with re-
spect to maturity has been interpreted in light of the
liquidity levels corresponding to their specified levels.
The results summarized in Table 1 denote that the num-
ber of violations observed are 3,593 out of the total obser-
vations of 40,298 in the case of call options that amounts
to 8.92 per cent of the total number of observations
analysed. Likewise, 1,815 violations are found out of
35,171 observations for put options that accounts for 5.16
per cent of the total number of observations examined. In
addition to this, the results regarding the different levels
of liquidity, summarized in Table 1, clearly indicate that
the mean percentage of the normalized violations (mag-
nitude) decreases as the liquidity increases. The majority
of the violations in this category, i.e., about 96 per cent of
the violations both in the case of call and put options, are
confined to the thinly and moderately traded options
which can be designated as unexploitable because of (i)
higher bid-ask spread and (ii) difficulty in implementa-
tion of the strategy. Also, for the highly liquid contracts
(which are approximately 4 per cent of the total viola-
tions both in the case of call and put options) where the
possibility of exploitability is quite high as the bid-ask
spread is expected to be considerably low, the means of
abnormal profits are merely 0.08 and 0.13 per cent for call
and put options respectively. In general, such meagre
exploitable profit opportunities are clearly not attractive
propositions for the retail arbitrageurs as the brokerage
and securities transaction tax (STT) for exploiting such
opportunities amounts to 0.10 and 0.093 per cent for call
and put options respectively.
However, such opportunities might be exploitable on the
part of the institutional investors and the trading mem-
ber organizations (brokerage firms) as these firms enjoy
relatively lower transaction costs of 0.06 and 0.056 per
cent in the cases of call and put options respectively.
Moreover, amongst the violations relating to highly liq-
uid contracts, only 25 per cent observations, i.e., the third
quartile (as reported in the Table 1) seem to be exploitable
as the profit for such violations is higher than 0.09 and
0.16 per cent for call and put options respectively. The
remaining 75 per cent observations amongst highly liq-
uid category yield the returns that are fairly below the
exploitable level in the presence of transaction costs.
Therefore, only 1 per cent (25 % of 4 %) of the violations
for the call as well as put options seems to be exploitable
by institutional investors and trading member organiza-
tions after factoring transaction costs.
Besides, an attempt has been made to analyse the
behaviour of liquidity (number of contracts traded) in S&P
CNX Nifty index futures contracts vis-à-vis maturity over
the period of analysis. This has been done in view of the
fact that the liquidity of futures plays an important role in
assessing the exploitability of mispricing signals identi-
fied using futures prices. To gauge the behaviour of li-
quidity across the different levels of maturity, the total
and average number of contracts traded have been classi-
fied as per the three levels of maturity in the Indian de-
rivatives market, namely, near-the-month contracts (NTM)
having ‘0-30’ days to maturity; next-the-month (NXTM)
having ‘31-60’ days to maturity, and far-the-month (FTM)
having ‘61-90’ days to maturity. The results in this re-
gard are depicted in Figures 1 and 2.
Figure 1: Total Number of Contracts Traded
Classified as per the Three Levels of Maturity
Maturity-wise Liquidity of S&P CNX Nifty Futures in India,
June 2001-07
NXTM
NTM 9.43%
90.34%
FTM
0.22%

Table 1: Liquidity-wise Magnitude of Violations of Lower Boundary Conditions for Call and Put Options in Indian
Securities Market (June 2001-07)

Liquidity Call Options Put Options

Number of Magnitude of Violations Number of Magnitude of Violations
Violations (in Percentage) Violations (in Percentage)
Mean SD Q1 Q2 Q3 Mean SD Q1 Q2 Q3
Thinly traded 3,066 (85.3) 0.93 2.10 0.10 0.30 0.79 1,557 (85.8) 0.85 1.62 0.10 0.34 0.88
Moderately traded 372 (10.4) 0.19 0.31 0.04 0.09 0.20 182 (10.0) 0.38 0.90 0.04 0.11 0.31
Highly traded 155 (4.3) 0.08 0.13 0.01 0.04 0.09 76 (4.2) 0.13 0.22 0.03 0.05 0.16
Total 3,593 0.84 1.96 0.08 0.24 0.67 1,815 0.78 1.54 0.09 0.28 0.79
Total number of observations analysed 40,298 35,171
Percentage of violations observed 8.92 % 5.16 %
Note: 1. Figures in parentheses indicate percentage.
2. In the table, SD, Q1, Q2 and Q3 denote standard deviation, first quartile, second quartile (i.e., median) and third quartile respectively.

VIKALPA • VOLUME 36 • NO 1 • JANUARY - MARCH 2011 21

Figure 2: Average Number of Contracts Traded
Classified as per the Three Levels of Maturity
Maturity-wise Average Liquidity of S&P CNX Nifty Futures in
India, June 2001-07
Average Liquidity
In another significant observation, the frequency of viola-
tions across different levels of maturity signifies a decreas-
ing trend with an increase in the time to maturity. As
reported in Table 2, majority of the mispricing signals are
confined to the options having ‘0-7’ and ‘8-30’ days to
maturity, approximately 94 per cent in call options and
90 per cent in put options. However, for the next two lev-

els, i.e., ‘31-60’ and ‘61-90’ days to maturity, the com-

bined percentage is merely 5.9 per cent and 9.8 per cent
for call and put options respectively. The concentration
of the violations in the ‘0-30’ days to maturity category
and especially in ‘0-7’ days to maturity is quite similar to
that reported by Bhattacharya (1983) for the US market
where 42 per cent of the total violations had one week or
Maturity Levels less to maturity.

The results clearly indicate that the liquidity of futures is
confined to the NTM contracts as 90.34 per cent of the
total number of contracts traded (along with the highest
average) belong to this category. Therefore, the NTM fu-
tures contracts can be designated as the most traded con-
tracts and are expected to have negligible bid-ask spread
compared to NXTM and FTM.
The concentration of violations in ‘0-7’ days to maturity
category can be attributed to the fact that most of the
arbitrageurs, in general, try to unwind their arbitrage
positions when the options are nearing maturity. On ac-
count of this, the liquidity in such options is expected to
be very thin as there are only a few or no buyers. This, in
turn, causes the transaction costs especially the bid-ask

Table 2: Magnitude of Violations of Lower Boundary Conditions in Indian Options Market as per ‘the Specified
Levels of Time-to-Maturity and their Sub-classification as per the Specified Levels of Liquidity’ for Call
and Put Options (June 2001-07)

Days to Liquidity Call Options Put Options

Maturity No. of Magnitude of Violations No. of Magnitude of Violations
Violations (in Percentage) Violations (in Percentage)
Mean SD Q1 Q2 Q3 Mean SD Q1 Q2 Q3
‘0-7’ Days Thinly traded 1,327(77.29) 0.92 2.17 0.10 0.28 0.76 744(82.21) 0.70 1.32 0.09 0.24 0.70
Moderately traded 249(14.50) 0.15 0.23 0.03 0.08 0.17 101(11.16) 0.35 1.08 0.03 0.08 0.21
Highly traded 141(8.21) 0.08 0.14 0.01 0.04 0.09 60(6.63) 0.09 0.12 0.03 0.05 0.11
Overall 1,717 0.74 1.94 0.07 0.18 0.58 905 0.62 1.26 0.07 0.19 0.63
‘8-30’ Days Thinly traded 1,536(92.20) 0.88 1.86 0.11 0.31 0.80 647(88.51) 0.99 1.93 0.11 0.41 1.03
Moderately traded 117(7.02) 0.23 0.30 0.05 0.15 0.26 68(9.30) 0.36 0.60 0.05 0.16 0.42
Highly traded 13(0.78) 0.08 0.10 0.01 0.05 0.10 16(2.19) 0.27 0.40 0.03 0.13 0.34
Overall 1,666 0.83 1.80 0.10 0.28 0.74 731 0.92 1.84 0.10 0.36 0.95
‘31-60’ Days Thinly traded 186(96.37) 1.14 3.18 0.13 0.34 0.89 149 (93.12) 0.91 1.38 0.19 0.46 0.85
Moderately traded 6(3.11) 0.74 0.60 0.04 0.09 0.48 11(6.88) 0.56 0.50 0.18 0.43 0.77
Highly traded 1(0.52) NA NA NA NA 0(0.00) NA NA NA NA NA
Overall 193 1.39 3.14 0.12 0.34 0.81 160 0.89 1.34 0.19 0.45 0.88
‘61-90’ Days Thinly traded 17(100) 1.67 1.81 0.31 0.55 3.36 17 (89.47) 1.89 2.00 0.53 1.05 2.50
Moderately traded 0 (0.00) NA NA NA NA NA 2 (10.53) 1.62 0.74 1.10 1.62 2.14
Highly traded 0(0.00) NA NA NA NA NA 0(0.00) NA NA NA NA NA
Overall 17 1.67 1.81 0.31 0.55 3.36 19 1.86 1.90 0.61 1.10 2.43
Note: 1. Figures in parentheses indicate percentage.
2. In the table, SD, Q1, Q2 and Q3 denote standard deviation, first quartile, second quartile (i.e., median), and third quartile respectively.

22 TESTING LOWER BOUNDARY CONDITIONS FOR THE S&P CNX NIFTY INDEX OPTIONS ...
spread to be considerably high. Therefore, lack of liquid-
ity and less time to maturity might be cited as the major
reasons why such observed mispricing signal remained
unexploited.
In addition to this, the reason why such options remained
unexploited becomes clearer when they are seen in light
of their corresponding levels of liquidity as reported in
Table 2. The results indicate that only 8.21 per cent and
6.63 per cent of the total violations in ‘0-7’ days to matu-
rity category for call and put options respectively belong
to the highly traded category which is apparently exploit-
able. However, their magnitude, i.e., the mean percentage
turned out to be 0.08 per cent and 0.09 per cent respec-
tively; even this insignificant number virtually ceases to
be profitable when the transaction costs are considered
for the retail investors. Moreover, from the viewpoint of
institutional investors/trading member organizations,
one-fourth of such opportunities seem to be profitable as
the third quartile turns out 0.09 per cent and 0.11 per cent
for call and put options respectively. And, obviously, less
than 25 per cent of such opportunities would be profit-
able for retail investors. Precisely, 2 per cent (25 % of 8.21
%) and 1.6 per cent (25 % of 6.63 %) of the total observa-
tions having ‘0-7’ days to maturity seem to be exploitable
in call and put options respectively. And, the remaining
violations in ‘0-7’ days to maturity category (pertaining
to the relatively illiquid category) amount to 91.79 per
cent and 93.37 per cent in the cases of call and put op-
tions respectively. A plausible explanation for the exist-
ence of such options, despite the higher magnitude of
profit they offer, could be the higher bid-ask spread.
Notably, the behaviour of violations pertaining to the ‘8-
30’ days to maturity category is quite similar to that of ‘0-
7’ days to maturity category as the violations belonging
to the highly liquid category are only 0.81 per cent in the
case of call options and 2.19 per cent in the cases of put
options of the total violations registered in this category.
Equally revealing observation is that the majority of the
violations belong to the relatively lower levels of liquid-
ity, i.e., approximately 99 per cent and 98 per cent in the
cases of call and put options respectively. Empirically,
for the call options, the violations belonging to the highly
liquid contracts in this category clearly seem to be
unexploitable in the presence of transaction costs. In con-
trast, the violations in the case of put options, per-se, seem
to be exploitable as the average magnitude of violations
is 0.27 per cent. However, the number of exploitable vio-
VIKALPA • VOLUME 36 • NO 1 • JANUARY - MARCH 2011
lation further goes down as only the third quartile pos-
sesses profitable opportunities in the presence of trans-
action costs. In short, the percentage of such exploitable
violations in put options becomes considerably low, i.e.,
0.55 per cent (25 % of 2.19 %).
In addition to the above, the last two levels of time to
maturity, i.e., ‘31-60’ and ‘61-90’ days to maturity clearly
depict a lack of the highly liquid contracts for call as well
as put options. It may be noted that the majority of viola-
tions for both categories pertain to the thinly traded cat-
egory, viz., 96.37 per cent and 100 per cent in the cases of
call options; 93.12 per cent and 89.47 per cent for put
options. Also, the mean percentages of magnitude of these
levels of maturity are significantly high compared to the
first two levels and, prima-facie, seem to be exploitable.
But the exploitability of such abnormal profit opportuni-
ties is questionable in view of the lack of liquidity in such
options in the Indian options market. The unexploitability
of such violations is reinforced by the fact that liquidity
for the futures contracts having ’31-60’ and ’61-90’ days
to maturity is relatively very low (Figure 1) which causes
bid-ask spread for futures contracts to be high. Further
Figure 2 depicts that the average number of contracts for
such futures contracts are 13,138 and 310 vis-à-vis 1,14,494
contracts in futures having ‘0-30’ days to maturity.
In short, as far as the exploitability of the observed
mispricing signals is concerned, the results regarding
maturity are in line with those in the case of liquidity as
the majority of violations pertain to the relatively illiquid
categories for all the four levels of maturity for call as well
as put options.
Statistical Significance of the Differences in the
Magnitude of Violations
In view of the above findings, it can be observed that there
seems to be a difference in the mean percentages of the
magnitudes of violations among the specified levels of
liquidity and maturity for call as well as put options. And,
to validate the finding statistically, a well-known statisti-
cal test — Analysis of Variance (ANOVA) — was pro-
posed initially. However, before applying the test statistics
on the data, the main assumption of ANOVA, i.e., the
samples have been drawn from a normally distributed
population, has been validated using the one-sample
Kolmogorov-Smirnov statistics. The results are summa-
rized in Table 3.
23
Table 3: Summary of One-sample Kolmogorov-Smirnov Statistics to Assess Normality

Call Options Put Options

Variable LBC_Normalized (in percentage) LBC_Normalized (in percentage)
Number of Observations 3,593 1,815
Normal Parameters(a,b) Mean 0.819510 0.776377
Std. Deviation 1.9641043 1.5417408
Most Extreme Differences Absolute 0.338 0.307
Positive 0.291 0.250
Negative -0.338 -.307
Kolmogorov-Smirnov Z 20.285 13.097
Asymp. Sig. (2-tailed) 0.000 0.000
a Test distribution is normal
b Calculated from data.

Since the results depict severe departure from the nor-
mality (revealed by the Kolmogorov-Smirnov (KS) statis-
tics), ANOVA cannot be applied as it requires data to
follow the normal distribution. Therefore, the differences
have been analysed using a non-parametric statistics
which does not require the data to follow any specified
distribution. The test statistics applied in the present study
is Kruskal-Wallis (H-statistics) test which is a non-para-
metric substitute for the one-way ANOVA. In addition to
this, Dunn’s multiple comparison test has been used for
post-hoc analysis of all possible pairs in the analysis.
The results of H statistics and Dunn’s test for the differ-
ences across the specified levels of liquidity and maturity
are summarized in Tables 4 (a) and (b), 5 (a) and (b) re-
spectively.
The significance values given in Tables 4 (a) and 5 (a)
clearly indicate that the differences among the specified
levels of liquidity as well as maturity are significant even
at 1 per cent level of significance for both call and put
options. Moreover, the post-hoc diagnosis, i.e., Dunn’s
multiple comparison test signifies that magnitude of vio-
lations (in percentage) for the thinly traded options is
significantly different from that for the moderately traded
as well as highly traded options both for call and put
options. The magnitudes of violations across the speci-
fied levels of maturity are lower for exploitable options
(i.e., ‘0-7’ days to maturity and ‘8-30’ days to maturity)
compared to unexploiatble options (i.e., ’31-60’ days to
maturity and ’61-90’ days to maturity) for call as well as
put options; however, all the possible pairs are not sig-
nificantly different at 5 per cent level of significance.

Table 4(a): Kruskal-Wallis (H-statistics) Test for the Differences among the Violations across the Specified Levels
of Liquidity for Call and Put Options (June 2001-07)

Liquidity Call Options Put Options

Rank Test Statistics (a,b) Rank Test Statistics (a,b)
N Mean Rank Chi-Square df Sig. N Mean Rank Chi-Square df Sig.
Thinly traded 3,066 1,935.50 1,557 961.24
Moderately traded 372 1,124.32 393.42 2 0.000 182 653.04 122.93 2 0.000
Highly traded 155 671.87 76 427.87
a. Kruskal Wallis Test
b. Grouping Variable: Liquidity

Table 4(b): Dunn’s Test for Multiple Comparisons amongst the Specified Levels of Liquidity for Call and Put Options

Dunn’s Multiple Comparison Test Call Options Put Options

Difference in Rank Sum Significant (P < 0.05) Difference in Rank Sum Significant (P < 0.05)
Thinly traded vs.Moderately traded 810 Yes 308.2 Yes
Thinly traded vs.Highly traded 1,300 Yes 533.4 Yes
Moderately traded vs. Highly traded 450 Yes 225.2 Yes

24 TESTING LOWER BOUNDARY CONDITIONS FOR THE S&P CNX NIFTY INDEX OPTIONS ...
Table 5(a): Kruskal-Wallis (H-statistics) Test for the Differences among the Violations across the Specified Levels
of Maturity for Call and Put Options (June 2001-07)

Maturity Call Options Put Options

Rank Test Statistics (a,b) Rank Test Statistics (a,b)
N Mean Rank Chi-Square df Sig. N Mean Rank Chi-Square df Sig.
0-7 days to maturity 1717 1,664.76 905 817.97
8-30 days to maturity 1666 1,897.63 731 971.14
62.602 3 0.000 70.955 3 0.000
31-60 days to maturity 193 2,040.65 160 1,066.56
61-90 days to maturity 17 2,525.06 19 1,432.00
a. Kruskal Wallis Test b. Grouping Variable: Maturity

Table 5(b): Dunn’s Test for the Multiple Comparisons amongst the Specified Levels of Maturity for Call and Put
Options

Dunn’s Multiple Comparison Test Call Options Put Options

Difference in Significant Difference in Significant
Rank Sum (P < 0.05) Rank Sum (P < 0.05)
0-7 days to maturity vs. 8-30 days to maturity -230 Yes -150 Yes
0-7 days to maturity vs. 31-60 days to maturity -380 Yes -250 Yes
0-7 days to maturity vs. 61-90 days to maturity -860 Yes -610 Yes
8-30 days to maturity vs. 31-60 days to maturity -140 No -95 No
8-30 days to maturity vs. 61-90 days to maturity -630 No -460 Yes
31-60 days to maturity vs. 61-90 days to maturity -480 No -370 Yes

In operational terms, the results imply that the average
magnitude of violations for exploitable options contracts
is significantly different from those for options contracts
which can be designated as unexploitable. Empirically,
the finding validates that the magnitude of exploitable
violations is significantly less than that in the case of
unexploitable options. It demonstrates a good sign for
the market that the truly exploitable mispricing opportu-
nities were meagre in magnitude and significantly no-
ticeable violations existed only in the cases of unexploi-
table contracts due to lack of liquidity in such options.
The Learning Curve
In addition, an effort has been made to analyse the
behaviour of the mispricing signals over the years under
reference. This part of the paper attempts to test the learn-
ing hypothesis for call as well as put options markets in
the Indian context. The hypothesis warrants improvement
in the market efficiency over the years as investors are
expected to be more familiar/experienced with the new
market year after year and, thus, are expected to behave
more rationally in pricing the options contracts. To put it
explicitly, it has been hypothesized that the mispricing
signals should depict a declining trend for call as well as
put options. The examination of the violations over the
years under reference is similar with the study done by
Mittnik and Rieken (2000).
In this regard, the results, summarized in Table 6 and
Figure 3, indicate that the percentage of violations in call
options has shown an increasing (counterintuitive) trend
over the years except in the last year (2006-07) of the study.
The percentage has gone up from 6.21 per cent in the year
2001-02 to 10.47 per cent in the year 2005-06 with an
alarming increase of 68.59 per cent. The finding clearly
indicates violation of the learning hypothesis for call op-
tions. In contrast, the results regarding the put options,
conforming to the learning hypothesis, have shown a
declining trend, i.e., percentage of violations has been
decreasing over the years of analysis as presented in Table
6 and Figure 4. The percentage of violations has declined
from 7.63 per cent in the year 2001-02 to 3.09 per cent in
the year 2005-06 with a considerable decrease of 59.50
per cent. This validates the warranted improvement in
the efficiency of the put options market which, evidently,
could not be observed in the case of call options market.
The persistence of violations in the case of call options
and observed decline in the case of put options are in line
with those reported by Mittnik and Rieken (2000) in the
context of German index options market.

VIKALPA • VOLUME 36 • NO 1 • JANUARY - MARCH 2011 25

Table 6: Frequencies of the Violations of Lower Boundary Conditions for Call and Put Options (June 2001-07)

Year Call Options Put Options

No. of Observations No. of Violations Percentage No. of Observations No. of Violations Percentage
Analysed Observed Analysed Observed
2001-02 3,496 217 6.21 2,557 195 7.63
2002-03 3,898 283 7.26 3,376 248 7.35
2003-04 7,173 700 9.76 6,189 412 6.66
2004-05 7,010 721 10.29 6,702 323 4.82
2005-06 9,323 976 10.47 7,931 377 4.75
2006-07 9,398 696 7.41 8,416 260 3.09
Total 40,298 3593 8.92 35,171 1815 5.16

Figure 3: Percentage of Violations in Relation to the have been exploited has increased over the years. How-
Total Observations Analysed for Call Options ever, the exploitability of such arbitrage opportunities can
The Learning Curve_Call Options be ascertained if we look at the ‘magnitudes of abnormal
profits’ they offered.

In the year 2001-02, there are no violations pertaining to

Figure 4: Percentage of Violations in Relation to the
Total Observations Analysed for Put Options
The Learning Curve_Put Options
the highly liquid category (which are the most exploit-
able as the bid-ask spread for such options is assumed to
be very low) for call as well as put options. Moreover, the
moderately traded options, where the bid-ask spread is
assumed to be relatively high compared to the highly
traded options, possess a mean percentage of 0.14 and
0.20 for call and put options respectively which, per se,
seem to be exploitable. However, their unexploitability
could be attributed to the high bid-ask spread. Apart from
this, for the rest of the five years under reference (from
2002-03 to 2006-07), the percentage of violations belong-
ing to the highly liquid category has offered considerably
low abnormal profits as indicated by the third quartiles
for both call and put options. And, therefore, such viola-
tions seem to be unexploitable in the presence of transac-
tion cost except the year 2003-04 for call options (as the
third quartile is 0.17 per cent); years 2005-06 and 2006-07
for put options(as the third quartiles are 1.07 and 0.16 per
cent).

In short, no exploitable violations (considering the bid-

Further, the results summarized in Table 7 reveal that the
percentage of violations belonging to the thinly traded
category has declined over the years for both call (except
the last year, 2006-07) and put options. This finding, per
se, indicates that the percentage of violations which could
ask spread and transaction costs) were registered in the
first four years of analysis for call as well as put options
except the third year, i.e., 2003-04 in the case of call op-
tions where a negligible 0.39 per cent (25 % of 1.57 %) of
all the violations observed seem to be exploitable. At the
same time, the last two years (2005-06 and 2006-07) of
analysis did not show any exploitable violations for call
options. In contrast, the results regarding the put options
depict that a meagre 1.86 per cent and 2.79 per cent of
violations were exploitable in the years 2005-06 and 2006-

26 TESTING LOWER BOUNDARY CONDITIONS FOR THE S&P CNX NIFTY INDEX OPTIONS ...
Table 7: Magnitude of Violations of the Lower Boundary Conditions and their Sub-Classification as per the
Specified Levels of Liquidity in the Indian Options Market (June 2001-07)

Year Liquidity Call Options Put Options

No. of Magnitude of Violations No. of Magnitude of Violations
Violations (in Percentage) Violations (in Percentage)
Mean SD Q1 Q2 Q3 Mean SD Q1 Q2 Q3
2001-02 Thinly liquid 212 (97.70) 0.60 1.13 0.08 0.21 0.61 192 (98.46) 0.61 1.13 0.07 0.19 0.65
Moderately liquid 5(2.30) 0.14 0.06 0.08 0.15 0.19 3(1.54) 0.20 0.25 0.05 0.08 0.28
Highly liquid 0(0.00) NA NA NA NA NA 0(0.00) NA NA NA NA NA
Overall 217 0.59 1.11 0.08 0.20 0.58 195 0.60 1.12 0.07 0.19 0.64
2002-03 Thinly liquid 257(90.81) 0.47 0.93 0.07 0.18 0.44 239(96.37) 0.53 0.82 0.08 0.24 0.59
Moderately liquid 24(8.48) 0.10 0.09 0.04 0.06 0.15 09(3.63) 0.06 0.06 0.03 0.05 0.06
Highly liquid 2(0.71) 0.05 0.01 0.04 0.05 0.05 0(000) NA NA NA NA NA
Overall 283 0.44 0.90 0.07 0.17 0.42 248 0.51 0.81 0.07 0.21 0.56
2003-04 Thinly liquid 628 (89.72) 1.08 2.78 0.11 0.34 0.90 358 (86.89) 1.19 2.00 0.15 0.56 1.21
Moderately liquid 61(8.71) 0.16 0.21 0.04 0.10 0.19 48(11.65) 0.41 0.68 0.06 0.15 0.39
Highly liquid 11(1.57) 0.10 0.09 0.03 0.07 0.17 6(1.46) 0.13 0.22 0.02 0.05 0.09
Overall 700 0.99 2.65 0.10 0.30 0.78 412 1.09 1.90 0.13 0.46 1.05
2004-05 Thinly liquid 620 (85.99) 0.90 1.64 0.10 0.25 0.84 263(81.42) 0.56 0.90 0.09 0.22 0.66
Moderately liquid 76 (10.54) 0.15 0.29 0.03 0.06 0.16 47(14.55) 0.15 0.22 0.03 0.06 0.16
Highly liquid 25(3.47) 0.14 0.19 0.02 0.06 0.12 13(4.03) 0.20 0.45 0.02 0.03 0.08
Overall 721 0.79 1.55 0.07 0.20 0.70 323 0.49 0.84 0.06 0.17 0.53
2005-06 Thinly liquid 780(79.92) 0.99 1.88 0.14 0.39 0.88 306(81.17) 1.17 2.32 0.15 0.46 1.11
Moderately liquid 134 (13.73) 0.26 0.42 0.05 0.12 0.30 43 (11.40) .29 .42 0.07 0.11 0.29
Highly liquid 62(6.35) 0.10 0.16 0.02 0.05 0.11 28(7.43) .13 .13 0.04 0.09 0.17
Overall 976 0.84 1.72 0.10 0.29 0.74 377 0.99 2.13 0.10 0.38 0.94
2006-07 Thinly liquid 569 (81.75) 1.06 2.55 0.09 0.29 0.76 199 (76.54) .77 1.78 0.13 0.40 0.89
Moderately liquid 72 (10.35) 0.13 0.18 0.02 0.08 0.17 32 (12.31) 0.90 1.82 0.06 0.30 0.54
Highly liquid 55(7.90) 0.04 0.05 0.01 0.03 0.06 29(11.15) 0.10 0.11 0.03 0.06 0.16
Overall 696 0.89 2.33 0.06 0.19 0.59 260 0.71 1.23 0.09 0.31 0.75
Note: 1. Figures in parentheses indicate percentage.
2. In the table, SD, Q1, Q2 and Q3 denote standard deviation, first quartile, second quartile (i.e., median) and third quartile
respectively.

07 respectively. However, if we look at the absolute fig-
ures, all the exploitable violations in call as well as put
options seem to be negligible, i.e., only 3 cases (25% of 11)
in call options for the year 2003-04; only 7 cases (25% of 28
and 29) in put options for the years 2005-06 and 2006-07.
Comparison of Call and Put Options
In order to ascertain the levels of pricing efficiency in the
two markets, namely, call options market and put op-
tions market, a comparison has been drawn between these
markets. The number of violations observed are 3,593 out
of a total number of 40,298 observations analysed in the
case of call options. Likewise, 1,815 violations have been
observed out of 35,171 observations for put options. As
far as the frequency of violations is concerned, the call
options market seems to be more inefficient compared to
the put options market as the number as well as the per-
centage (8.92% of total observations analysed in call op-
tions compared to 5.16% in put options) of violations are
higher vis-à-vis those in the case of put options. Notwith-
standing the results regarding the frequency, the magni-
tude of violations in the cases of call as well as put options
seems to be approximately equal, the respective figures
being 0.82 and 0.78 per cent.

VIKALPA • VOLUME 36 • NO 1 • JANUARY - MARCH 2011 27

The results are more revealing based on the absolute fig-
ures as all the exploitable violations pertaining to call as
well as put options seem to be negligible. It is eloquently
borne out by the fact that there are only 3 cases for call
options and only 14 for put options; all the remaining
violations might have remained unexploited due to the
lack of liquidity. Our finding that the lower boundary
condition for call options is violated more frequently com-
pared to put options is similar to the one documented by
Puttonen (1993a), a study carried out in the context of
Finnish index options market.
Moreover, the number of violations of lower boundary
conditions (using spot prices) documented by Dixit, Yadav
and Jain (2009), another study in the Indian context, are
7,019 and 1,544 in the cases of call and put options re-
spectively, while analysing the same number of observa-
tions. However, in the present study, the number of
violations are 3,593 and 1,815 for call and put options
respectively. The reason behind the decrease (increase)
in the number of violations for the call (put) options might
be the under-pricing of the futures contracts. And, the
short-selling of the stock basket is needed to exploit the
arbitrage opportunity arising on account of the under-
pricing of futures. Therefore, the under-pricing of the fu-
tures can be attributed to the fact that short-selling has
been banned during the period under reference in the
Indian securities market. The impact of short-selling con-
straints on the pricing of futures contracts has been vali-
dated empirically by numerous studies, carried out in
different markets across the globe, for example, MacKinlay
and Ramaswamy (1988), in the context of the US market;
Puttonen and Martikainen (1991), in the context of the
Finnish market; Lim (1992), in the context of the Japanese
market; Puttonen (1993b), in the context of the Finnish
market; Berglund and Kabir (2003), in the context of the
UK market; Bialkowski and Jakubowski (2008), in the
context of the Polish market. These studies have attrib-
uted the absence of short-selling facility in the market as
a potential reason for the underpricing of futures con-
tracts.
Further, explaining the higher frequency of violations in
the case of call options, Mittnik and Rieken (2000) opined
that selling the asset short, particularly, when the asset is
an index, becomes very difficult. However, in the present
study, this could not be a correct explanation to the higher
frequency of violations in call options since in order to
28 TESTING LOWER BOUNDARY CONDITIONS FOR THE S&P CNX NIFTY INDEX OPTIONS ...
exploit the arbitrage opportunities using futures market,
the arbitrageur does not have to short the stock basket;
rather, he needs to sell the futures that is easily possible.
Therefore, it is reasonable to conclude that the indirect
impact of the short-selling constraints on the efficiency of
the options market on account of the interrelationship of
the index options and index futures market has been one
of the major reasons amongst others (e.g., liquidity) for
the existence of mispricing signals in the Indian options
market. In short, the impact of short-selling constraints
cannot be ignored even if the violations are identified
using futures contracts as the efficiency of futures market
does impact the efficiency of options market and, which,
in turn, can be ensured when short-selling is allowed.
CONCLUDING OBSERVATIONS
The study attempts to test the lower boundary conditions
for the S&P CNX Nifty index option prices using the fu-
tures prices on the same index in the Indian securities
market. The results of the study are, more or less, in line
with those drawn in the case of the US market (e.g., con-
centration of violations in ‘0-7’ days to the maturity cat-
egory) except the magnitude and frequency of violations
which have been observed to be more pronounced in the
Indian options market alike the Finnish index options
market. The clustering of violations is quite similar to that
reported by Bhattacharya (1983), a study conducted in
the US market, where 42 per cent of the total violations
had one week or less to maturity. Also, the frequency of
violations in call options have been found to be more pro-
nounced compared to that in put options. At the same
time, however, the magnitude of violations remained al-
most the same for call as well as put options. The viola-
tion of lower boundary indicates under-pricing of options
in the Indian securities market. The finding that the op-
tions are under-priced is consistent with that of Varma
(2002), a study carried out in the Indian context.
Moreover, as far as comparative performance of the In-
dian options market vis-à-vis its international counter-
parts is concerned, the findings of the study can be
compared with those of a few studies in the context of
two more markets from the developed world, i.e., the US
and Germany. The US and German markets have been
chosen in view of the fact that these markets facilitate
comparison of a developing economy with its developed
counterpart. For example, the studies of Galai (1978) and
Bhattacharya (1983) which analysed call options traded
on Chicago Board Option Exchange (CBOE), USA, re-
ported that merely 2.95 per cent and 2.38 per cent of the
observations respectively violated the boundary condi-
tion. Besides, in the context of German index options
market, a study by Mittnik and Rieken (2000) reported
nearly 2 per cent violation in the case of call options and
nearly 1 per cent in the case of put options, on an average,
over the years under analysis. The percentage of viola-
tions observed in the Indian options market, i.e., 8.92 per
cent of the observations analysed is substantially higher
compared to those observed in its developed counterparts.
However, it may be noted that Galai (1978), Bhattacharya
(1983), and Mittnik and Rieken (2000) used spot prices
whereas the present study uses futures prices of the un-
derlying asset. In sum, the number of violations observed
can be attributed to the joint inefficiency of the futures
and options market in India.
Though the frequency of violations remained quite high
in the Indian options markets compared to the US and
German markets, the exploitability of such violations (in
the presence of the transaction costs) remained confined
to being negligible on account of the dearth of liquidity. It
is eloquently borne out by the fact while the percentage of
violations turned out 8.92 and 5.16 in call and put op-
tions respectively, the absolute figures reduced to 3 and
14 exploitable observations, given the existing market
microstructure in India for the period under reference. In
other words, a significant number of violations remained
unexploitable, plausibly on account of the lack of liquid-
ity and the indirect impact of short-selling constraints
through the futures market.
The study is equally revealing as far as the behaviour of
the investors dealing with the options market in India is
concerned. It has been observed that the number of viola-
tions in the call options market has increased instead of
showing a warranted declining trend. In other words, it
implies that the irrationalities in the behaviour of inves-
tors, particularly in the call options market, have gone up
over the years. However, it is gratifying to note that the
put options market has behaved the way which is consis-
tent with the learning hypothesis, i.e., the number of vio-
lations has reduced with the passage of time. Thus, the
findings indicate that the put options market is emerging
to be more efficient vis-à-vis the call options market. How-
ever, the profit potential offered by highly traded oppor-
VIKALPA • VOLUME 36 • NO 1 • JANUARY - MARCH 2011
tunities both in the cases of call and put options seems to
be unexploitable in the presence of transaction costs.
Moreover, the dearth of liquidity in the case of otherwise
exploitable opportunities which carry higher profit po-
tentials has been another main inhibiting factor to
arbitragers.
Therefore, in short, it is reasonable to conclude that ma-
jority of violations in call as well as put options could not
be exploited on account of the existing market-microstruc-
ture in India during the period under reference (especially
short-selling constraint that caused under-pricing of fu-
tures to persist) and the dearth of liquidity in the options
market.
The aforesaid anomalies might have certain implications
for an emerging derivatives market like India. The two
notable implications in this regard are: (a) if the price
formation in the options market is not in line with the
sound principles of option pricing, it might not be help-
ful for price discovery in the underlying’s market and (b)
it might also hamper the overall hedging efficiency of the
market since the advanced dynamic hedging techniques
like delta hedging might turn out to be ineffective. Conse-
quently, the inefficient functioning of the derivatives mar-
ket might have adverse impact on allocation of capital --
the foremost functions that a derivative market is expected
to facilitate through effective hedging and correct price
discovery.
Notably, the recent development in the Indian derivatives
market, i.e., allowing the short-selling and establishment
of a proper lending and borrowing mechanism for the
securities being traded in ‘futures and options segment’
would certainly enhance the pricing efficiency of futures
market. And, therefore, the correct pricing of futures is
expected to facilitate better exploitability of the mispricing
signals and betterment of the options market on account
of their interrelationship. Also, the change in the basis for
charging the Securities Transaction Tax (STT) from con-
tract value to just premium would certainly reduce the
transaction cost to a marked extent and, therefore, is ex-
pected to bring in more liquidity to the market. Hopefully,
these developments would help the market to operate
closer to the equilibrium in prices and, therefore, will en-
sure better functioning of options market on its well-
identified functions, namely, risk hedging and price dis-
covery.
29
REFERENCES
Ackert, L F and Tian, Y S (2000). “Evidence on the Efficiency of Boundary Conditions for Toronto Stock Exchange Op-
Index Options Markets,” Federal Reserve Bank of Atlanta tions,” Journal of Finance, 40(2), 481-500.
Economic Review, 85(First Quarter), 40-52.
Kamara, A and Miller Jr, T (1995). “Daily and Intraday Tests
Ackert, L F and Tian, Y S (2001). “Efficiency in Index Options of European Put-call Parity,” Journal of Financial and Quan-
Markets and Trading in Stock Baskets,” Journal of Banking titative Analysis, 30(4), 519-539.
and Finance, 25(9), 1607-1634.
Lee, J H and Nayar, N (1993). “A Transactions Data Analysis
Baesel, J B; Shows G and Thorpe E (1983). “The Cost of Liquid- of Arbitrage between Index Options and Index Futures,”
ity Services in Listed Options,” Journal of Finance, 38(3), Journal of Futures Markets, 13(8), 889-902.
989-995.
Lim, K (1992). “Arbitrage and Price Behaviour of the Nikkei
Berg, E; Brevik, T and Saettem, M (1996). “An Examination of Stock Index Futures,” Journal of Futures Markets, 12(2),
the Oslo Stock Exchange Options Market,” Applied Fi- 151-162.
nancial Economics, 6(2), 103-113.
MacKinlay, A C and Ramaswamy, K (1988). “Index-Futures
Berglund, T and Kabir, R (2003). “What Explains the Differ- Arbitrage and Behaviour of Stock Index Futures Prices,”
ence between the Futures’ Price and its “Fair” Value? Review of Financial Studies, 1(2), 137-158.
Evidence from the Euronext Amsterdam,” Research in
Merton, R (1973). “Theory of Rational Option Pricing,” Bell
Banking and Finance, 3, 1-11.
Journal of Economics and Management Science, 4(1), 141-
Bhattacharya, M (1983). “Transactions Data Tests of Efficiency 183.
of the Chicago Board Options Exchange,” Journal of Fi-
Mittnik, S and Rieken, S (2000). “Lower-Boundary Violations
nancial Economics, 12(2), 161-185.
And Market Efficiency: Evidence from German DAX-
Bialkowski, J and Jakubowski, J (2008). “Stock Index Futures Index Options Market,” The Journal of Futures Markets,
Arbitrage in Emerging Markets: Polish Evidence,” In- 20(5), 405-424.
ternational Review of Financial Analysis, 17(2), 363-381.
Nilsson, R (2008). “The Value of Shorting,” Journal of Banking
Black, F and Scholes, M (1973). “The Pricing of Options and and Finance, 32(5), 880-891.
Corporate Liabilities,” Journal of Political Economy, 81(3),
Ofek, E; Richardson, M and Whitelaw, R F (2004). “Limited
637-659.
Arbitrage And Short Sales Restrictions: Evidence From
Chance, D M (1988). “Boundary Condition Tests of Bid and The Options Markets,” Journal of Financial Economics, 74(2),
ask Prices of Index Call Options,” The Journal of Financial 305-342.
Research, 11(1), 21-31.
Phillips, S and Smith, C Jr (1980). “Trading Costs for Listed
Chiras, D P and Manaster, S (1978). “The Information Content Options: The Implications for Market Efficiency,” Jour-
of Option Prices and a Test of Market Efficiency,” Journal nal of Financial Economics, 8(2), 179-201.
of Financial Economics, 6(2-3), 213-234.
Puttonen, V (1993a). “Boundary Conditions for Index Options:
Dixit, Alok; Yadav, Surendra S and Jain, P K (2009). “Viola- Evidence from The Finnish Market,” The Journal of Fu-
tion of Lower Boundary Conditions and Market Effi- tures Market, 13(5), 545-562.
ciency: An Investigation into Indian Options Market,”
Puttonen, V (1993b). “Stock Index Futures Arbitrage in Fin-
Journal of Derivatives and Hedge Funds, 15(1), 3-14.
land: Theory and Evidence in a New Market,” European
Fung, J K W and Chan, K C (1994). “On the Arbitrage Free Journal of Operational Research, 68(3), 304-317.
Pricing Relationship between Index Futures and Index
Puttonen, V and Martikainen, T (1991). “Short Sale Restric-
Options: A Note,” Journal of Futures Markets, 14(8), 957-
tions,” Economics Letters, 37(2), 159-163.
962.
Shastri, K and Tandon, K (1985). “Arbitrage Tests of the Effi-
Fung, J K W and Fung, A K W (1997). “Mispricing of Futures
ciency of the Foreign Currency Options Market,” Jour-
Contracts: A Study of Index Futures versus Index Op-
nal of International Money and Finance, 4(4), 455-468.
tions Contracts,” Journal of Derivatives, 5(2), 37-44.
Trippi, R (1977). “A Test of Option Market Efficiency Using a
Fung, J K W; Cheng, L T W and Chan, K C (1997). “The Intraday
Random-Walk Valuation Model,” Journal of Economics
Pricing Efficiency of Hang Seng Index Options and Fu-
and Business, 29(2), 93-98.
tures Markets,” Journal of Futures Markets, 17(2), 327-331.
Varma, J R (2002). “Mispricing of Volatility in Indian Index
Fung, J K W and Mok, H M K (2001). “Index Options-Futures
Options Market” Working paper, Indian Institute of
Arbitrage: A Comparative Study with Bid/Ask and
Management, Ahmedabad.
Transaction Data,” Financial Review, 36(1), 71–94.
Vipul (2008). “Cross-Market Efficiency in the Indian Deriva-
Galai, D (1978). “Empirical Tests of Boundary Conditions for
tives Market: A Test of Put-Call Parity,” The Journal of
CBOE Options,” Journal of Financial Economics, 6(2-3), 187-
Futures Markets, 28(9), 889-910.
211.
www.nse-india.com; www.rbi.org.in
Halpern, P J and Turnbull, S M (1985). “Empirical Tests of

30 TESTING LOWER BOUNDARY CONDITIONS FOR THE S&P CNX NIFTY INDEX OPTIONS ...
Alok Dixit is currently working as an Assistant Professor in
the Finance & Accounting Group at the Indian Institute of
Management Lucknow (IIML), India. He teaches Management
Accounting, Investment Management and Financial Deriva-
tives & Risk Management. He obtained his doctoral degree
(Ph.D.) from the Department of Management Studies, Indian
Institute of Technology Delhi (IIT Delhi) on the topic, ‘Pric-
ing Efficiency of S&P CNX Nifty Index Options’. He was
awarded Junior Research Fellowship of the University Grants
Commission (UGC-JRF) in management to pursue research
anywhere in India. He has published research papers in the
journals of national and international repute.
e-mail: alokdixit@iiml.ac.in
Surendra S Yadav is currently Professor of Finance in the
Department of Management Studies at the Indian Institute of
Technology (IIT), Delhi, India. He teaches Corporate Finance,
International Finance, International Business, and Security
Analysis and Portfolio Management. He has been a visiting
professor at the University of Paris, Paris School of Manage-
ment, INSEEC Paris, and the University of Tampa, USA. He
The market will decide how much profit to give you.
Only you can decide how much to limit your loss.
VIKALPA • VOLUME 36 • NO 1 • JANUARY - MARCH 2011
has published nine books and contributed more than 115 pa-
pers to research journals and conferences. He has also con-
tributed more than 30 papers to financial/economic
newspapers.
e-mail: ssyadav@dms.iitd.ac.in
P K Jain is Professor of Finance at the Department of Manage-
ment Studies at the Indian Institute of Technology (IIT), Delhi,
India. He has been the Modi Foundation Chair Professor as
well as Dalmia Chair Professor. He has more than 35 years’
teaching experience in subjects related to Management Ac-
counting, Financial Management, Financial Analysis, Cost
Analysis and Cost Control. He has been a visiting faculty at
the University of Paris I, Paris School of Management, AIT
Bangkok, Howe School of Technology Management at
Stevens Institute of Technology, New Jersey; and ICPE,
Ljubljana. He has published about a dozen textbooks and 11
research books/monographs. He has contributed more than
125 research papers in journals of national and international
repute.
e-mail: pkjain@dms.iitd.ac.in
— Linda Raschke
31