Volatility Forecasting and the Efficiency of the Toronto 35 Index Options Market

Abstract Existing research into Canadian options market efficiency is dated and focuses only on the stock options market. Until now no study has investigated the efficiency of the Toronto 35 index options market. This study fills the gap by examining the Toronto 35 index options market using a delta neutral straddle trading strategy. Straddle prices are computed by inserting different forecasts of volatility into the Black-Scholes option-pricing model We consider the recently developed GARCH conditional-variance forecasts, implied-volatility forecasts, and forecasts that combine the information contained in historical return data and option prices in the market. Without transaction costs, the straddle strategy is able to generate trading profits when the same day's prices (or ex post prices) are used both to detect mispricing and to initiate a trade position. The profits disappear when transaction costs are introduced. When the straddle position is initiated based on the following day's prices (or ex ante prices), with or without transaction costs, no significant profits are available with any of the volatility forecasts. We therefore conclude that the Toronto 35 index options market is efficient with respect to the straddle trading strategy using different volatility forecasts. The concept of capital market efficiency is central to the field of finance; as such, financial economists have studied the efficiency of capital markets for many years. The concept of efficiency, as it applies to information available in the marketplace, is important because it implies that in an efficient market, prices fully reflect all available information. That is, there are no exploitable correlations between future market returns and current information; investors who employ active trading rules cannot outperform the average market. Black and Scholes (1972) and Galai (1977,1978) were the first researchers to investigate options market efficiency. Since then, several authors have investigated the efficiency of a number of different options markets around the world, particularly in the United States. There are two different research approaches: boundary-conditions tests (Bhattacharya, 1983; Galai, 1978; Halpern & Turnbull, 1985), and some type of model-based test (Chance, 1986; Galai, 1977; Harvey & Whaley, 1992; Lamoureux & Lastrapes, 1993; Noh, Engle, & Kane, 1994; Stein, 1989). The former does not require any modeling assumptions, but leads to only a loose test in that it cannot detect small price deviations. The latter leads to much more powerful tests, but is subject to model-specification errors. In Canada several studies of options market efficiency have been conducted. For example, Chua and Mokklebost (1988), Halpern and Turnbull (1985), and Mandron (1988) studied the efficiency of the Canadian stock options market in the late 1970s and early 1980s. They found strong evidence of inefficiency, which they attributed to thin trading, nonsimultaneity of prices, unfamiliarity of the market, and a noncompetitive trading environment. However, these studies are rather dated and only focus on the stock options market. To date, there is no evidence regarding the efficiency of the Toronto 35 index options market, an important index options market in Canada. In this article, we use model-based tests to investigate the efficiency of the Toronto 35 index options market. A delta neutral straddle trading strategy driven by volatility forecasts is used. Employing volatility forecasts to study options-market efficiency is advantageous because volatility is a key determinant of option prices. In addition, because volatility can be computed from either historical returns or option prices, two distinct sources of information can be exploited. The article attempts to fill a major gap in the literature with respect to understanding Canadian options markets. The remainder of this article is organized as follows. …