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ITMs versus OTMs *
Author(s) -
Yoon SunJoong,
Kang So Hyun
Publication year - 2012
Publication title -
asia‐pacific journal of financial studies
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.375
H-Index - 15
eISSN - 2041-6156
pISSN - 2041-9945
DOI - 10.1111/j.2041-6156.2012.01081.x
Subject(s) - volatility (finance) , extant taxon , market liquidity , odds , local volatility , exotic option , economics , actuarial science , financial economics , moneyness , econometrics , implied volatility , valuation of options , monetary economics , mathematics , statistics , logistic regression , biology , evolutionary biology
By comparing liquidity and price discovery effects, the market microstructure literature insists that in‐the‐money options (ITMs) are informationally inferior to out‐of‐the‐money options. However, such an argument is at odds with the anecdotal point that ITMs may be more effective for hedging future volatility risk. ITMs are driven by institutional investors, who are considered to be informed traders, and can provide significant hedging benefits such that a hedging with ITMs requires fewer options and less frequent rebalancing. To clear this suspicion, we compare implied risk‐neutral densities, implied risk aversions and volatility forecasting performances. Contrary to the anecdotal evidence, our findings show the inferiority of ITMs in forecasting future volatilities, even after adjusting for the risk attitude of investors. These findings offer support for the arguments made in the extant market microstructure literature.