M. Wallmeier: Mispricing of Index Options with Respect to Stochastic Dominance Bounds?

June 1, 2017

For one-month S&P 500 index options, Constantinides, Jackwerth and Perrakis (2009) report widespread and substantial violations of stochastic dominance bounds. According to the subsequent study of Constantinides et al. (2011), the violations can be exploited to generate abnormal trading profits. The reported mispricing, which is far more extreme than known from the pricing kernel puzzle, calls into question that option markets meet the most basic requirements of rational pricing. However, we find that index options on the S&P 500, EuroStoxx 50 and DAX are priced almost perfectly in line with stochastic dominance bounds when adjusting for (a) the general level of option prices, (b) conditional volatility and © put-call parity in order to determine the appropriate (dividend-adjusted) underlying index level.