Examining the interrelation dynamics between option and stock markets using the Markov-switching vector error correction model

This study examines the dynamics of the interrelation between option and stock markets using the Markovswitching vector error correction model. Specifically, we calculate the implied stock prices from the Black–Scholes [6] model and establish a statistic framework in which the parameter of the price discrepancy between the observed and implied prices switches according to the phase of the volatility regime. The model is tested in the US S&P 500 stock market. The empirical findings of this work are consistent with the following notions. First, while option markets react more quickly to the newest stock–option disequilibrium shocks than spot markets, as found by earlier studies, we further indicate that the price adjustment process occurring in option markets is pronounced when the high variance condition is concerned, but less so during the stable period. Second, the degree of the co-movement between the observed and implied prices is significantly reduced during the high variance state. Last, the lagged price deviation between the observed and implied prices functions as an indicator of the variance-turning process.