The theory of options pricing portends that option prices are derived from the underlying asset prices and their price can only be discovered after the price of the underlying asset is known in the frictionless market. The frictions like information asymmetry would mean that the informed could either trade their information in options market or in stock markets. In such a situation, the options market would send cues for the stock market. The major theoretical contention is, therefore, do the underlying asset prices have information for the price discovery of options? On the contrary, do options prices have information for the underlying asset? These questions are previously researched and apparently compelling evidence is found on both sides of the divide. Besides, the lead-lag relationships between both markets are of immense significance given the participants’ ability to garner private information and find suitable avenues for investing. Therefore, it is only germane to research this question. The present paper attempts to explore the microstructural linkages in terms of information links, inventory-based links and hedging-based links between options markets and stock markets by putting all the arguments in perspective with an emerging market context. The results of the present study suggest that the options markets in India have information for stock market, while stock market has little information for options market. The present study finds evidence that support hedging-based links between the options and stock market, while the results are weak for inventory control.

A frictionless market is characterized by information flow that follows a Brownian motion (Kyle, 1985). When markets are efficient the price discovery happens after the information arrival, and since nobody can predict the information arrival, market prices would be unpredictable. According to the notion of frictionless markets, the options markets are redundant because they convey no additional information to underlying market (hereafter stock markets). Therefore, the theory of option pricing portends that stock prices have information for option prices and not vice versa. However, the frictions like information asymmetry would mean that the informed could either trade their information in options market or in stock markets. In such a situation, the options market would send cues for the stock market. Several studies have brought out the significance of microstructure linkages of options markets and stock markets with highly conflicting evidence.

According to Vijh (1990), the stock prices lead the options prices suggesting that it is the stock prices that have information and not the option prices. Typically, the bid-ask spreads in the options markets are higher and if the benefit from information is less than the spread then the informed will rather trade the information in stock market. Also, Stephen and Whaley (1990) find evidence to corroborate the results of Vijh (1990). Contrary to this, some of the recent studies report results which suggest that the options markets do convey information to the stock markets (Easley et al., 1998). Studies by Chakravarty et al. (2004) and Pan and Poteshman (2006) have come up with unambiguous results of informed trading in options markets.

Applied Finance Journal, Indian Derivatives Markets, Securities and Exchange Board of India (SEBI), Bombay Stock Exchange (BSE), National Stock Exchange (NSE), Market Microstructure Linkages, Emerging Options Market, Stock Market.