Testing the Expectations Hypothesis on the Term Structure of Volatilities Implied by Index Options : Study of the Indian Securities Market

This research paper is aimed at diagnosing the pricing inefficiencies prevailing in the Indian index options market. The inefficiencies are being revealed by testing the rational expectations hypothesis on the term structure of implied volatilities of index options. In the paper, an effort has been made to diagnose: (a) whether the implied volatilities, in the case of both short dated as well as long dated options, are mean-reverting or not; and (b) whether the volatilities implied by the long dated options are consistent with the future volatilities estimated on the basis of corresponding volatilities implied by short dated options, assuming rational expectations to hold. The implied volatilities are calculated by inverting the adjusted form of Black-Scholes model. For the analysis, daily data on index options based on National Stock Exchange index i.e. Samp;P CNX NIFTY has been used for the period from June 4, 2001 (starting date for index options in Indian securities market) to December 31, 2006. The analysis reveals that implied volatilities are, in fact, mean-reverting. However, implied volatility of long dated options is not evolving the way as warranted by rational expectations hypothesis, and the evidences of overreaction and underreaction are seen for both calls as well as put options