We begin with a brief description of the Taiwan Stock Exchange Corporation (TSEC). The Exchange maintains a total of 28 stock price indices, to allow investors to grab both overall market movement and different industrial sectors' performances conveniently. The indices may be grouped into market value indices and price average indices. The former are similar to the Standard & Poor's Index, weighted by the number of outstanding shares, and the latter are similar to the Dow Jones Industrial Average and the Nikkei Stock Average. The TSEC Capitalization Weighted Stock Index (TAIEX) is the most widely quoted of all TSEC indices.
TAIEX covers all of the listed stocks excluding preferred stocks, full-delivery stocks and newly listed stocks, which are listed for less than one calendar month. Up to December 2002, 593 issues were selected as component stocks from the 638 companies listed on the Exchange.
Trading on the Exchange starts at 09:00 and closes at 13:30. The orders can be entered half an hour before the trading session starts. Buy or sell orders are in standard unit or multiples of standard units. One standard trading unit is 1,000 shares, which is applicable to all listed stocks. Orders below 1,000 shares are considered odd-lot and that over 500,000 shares are block trading.
Under current trading rules, the closing price of a stock is simply the last traded price of the intra-day continuous auction of the trading day. Given that the closing price of securities is widely used by market participants as a benchmark for portfolio valuation as well as index calculation, the new system will accumulate orders for 5 minutes (from 1:25 p.m. to 1:30 p.m.) before the closing call auction.
The TSEC imposes a 7% price limits for all traded stocks. Within a trading day, the price for a single stock cannot move more than 7% from the previous price after adjusting for dividend and stock splits. Therefore, the maximum close to close 1-day return is 7% and the minimum return is -7%.
The official derivative market for risky assets, which is known as Taiwan Futures Exchange (TAIFEX), trades future contracts on TAIEX, the equivalent option contracts for calls and puts, and individual option contracts for blue-chip stocks.
Trading in the derivative market started in 1998. The market has experienced tremendous growth from the very beginning. Launched on December 24th, 2001, the TAIEX index options achieved a total of 43,824,511 contracts by the end of 2004, accounting for 74.10% of the market total for the year.
The TAIEX option contract is a cash-settled European option with trading during the three nearest consecutive months and the other 2 months of the March quarterly cycle (March, June, September, and December). The last trading day is the third Wednesday of the delivery month and the expiration day is the first business day following the last trading day. Trading occurs from 08:45 to 13:45. During the sample period covered by this research, the contract size is 50 New Taiwan dollars times the TAIEX index, and prices are quoted in points, with a minimum price change of one-tenth point (NT$5). The exercise prices are given in 100 index point intervals in spot month, the next two calendar months and 200 index point intervals in the additional two months from the March quarterly cycle.
It is important to point out that liquidity is concentrated on the nearest expiration contract.
Thus, during 2002 and 2004 almost 90% of crossing transactions occurred in contracts of this type.
Figure 3: TAIEX index level each trading day during the period of June 2002 through May 2004.
Index Trend
Time
Stock Index
020603 4000
4500 5000 5500 6000 6500 7000
040531
3.2. The data
Based on the following consideration, we use TAIEX call option traded daily on TAIFEX during the period from July 1, 2002 through June 30, 2004 for our empirical work. To ease computational burden and avoid the non-simultaneous data, for each day in the sample, only the last reported quote (prior to 1:30 PM) of each option contract is employed in the empirical tests. Note that the recorded TAIEX index values are not the daily closing index levels. Rather, they are the corresponding index levels at the moment when the option quote is recorded. Thus, there is no nonsynchronous price issue here.
Several exclusion filters are applied to construct the option price data. First, option price quotes that are time-stamped later than 1:30 PM are eliminated. This ensures that
the spot price is recorded synchronously with its option counterpart. Second, as options with less than six days and more than 100 days to expiration may induce liquidity-related biases, they are excluded from the sample.
Table 1: Sample Properties of TAIEX index options
Days-to-Expiration
The reported numbers are respectively the average quoted price, the standard deviation which are shown in parentheses, and the total number of observations (in braces), for each moneyness and maturity category.
These criteria yield a final daily sample of 7015 observations. Table 1 describes the
sample properties of the call option prices employed in this work. Average prices, standard deviations, and the number of available calls are reported for each moneyness category. Moneyness is defined as the ratio of the spot price to the exercise price.
A call option is said to be deep out-of-the money if the ratio S /K belongs to the interval
(
0 ,0.94)
; out-of-the-money (OTM) if0.94≤S/K<0.97; at-the-money (ATM) when 0.97≤S/K <1.03 ; in-the-money (ITM) when 1.03≤S/K <1.06 ; and deep-in-the-money if S/K >1.06.To proxy for riskless interest rates, we use the daily series of annualized Taiwan deposit 1 month rates from the Bank of Taiwan.