The limitation of monotonicity property of option prices: an empirical evidence

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Abstract:

Many option pricing models are based on the assumption that the underlying asset price follows one-dimensional diffusion process. An alternative approach is to test the properties that should hold for all models based on a given stochastic process for the underlying asset. Following PĂ©rignon (2006), we test the empirical validity of the monotonicity property for option prices by collecting all transaction data from 1 July 2006 to 31 December 2006 for option contracts traded on the Taiwan Futures Exchange (TAIFEX). We find that sampled intraday option prices violate the monotonicity property between 29.97% and 57% of the time, and that call and put prices often increase, or decrease, together. We also find evidence to show that the frequent violations of the monotonicity property are to a large extent attributable to microstructure effects and that they arise from rational trading tactics.

Document Type: Research Article

DOI: http://dx.doi.org/10.1080/00036840903427265

Affiliations: 1: Department of Business Administration,National Taipei University, No. 69, Section 2, Chien-Kuo N. RoadTaipei 105, Taiwan 2: Department of International Business,China University of Technology, Taipei, Taiwan

Publication date: September 1, 2011

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