Is the KOSPI 200 Options Market Efficient? Parametric and Nonparametric Tests of the Martingale Restriction

A number of studies on the S&P 500 index options market claim that the no-arbitrage assumption cannot be rejected for this market because either the martingale restriction defined in Longstaff (1995) cannot be rejected by the data, or, even when it is rejected, a large proportion of the violation can be explained by market friction factors. The present study singles out the effect of market inefficiency from market friction by testing the martingale restriction for the KOSPI 200 index options market, which is the most liquid and active options market in the world. Not only using the parametric methods adopted in previous studies but also using the nonparametric methods that enable us to avoid the model misspecification problem, we empirically present clear evidence of a violation of the martingale restriction. In addition, in contrast to the S&P 500 options market, regression analyses and robustness tests indicate that market friction factors can explain only a small portion of the percentage differences between option-implied and market-observed index prices. Overall, the results do not support the basic no-arbitrage assumption or the market efficiency in the KOSPI 200 options market.