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This thesis consists of three essays. The first two essays present empirical studies in which option market features related to information flows are examined. The third essay introduces a theoretical model to explain predictable dynamics in option pricing through the agents' learning process. In the first essay, I investigate the previously unexplored effects of asymmetric information on the adoption process of new equity options introduced into the market. I use a microstructure model to estimate measures of informational asymmetries. I discover that high informational asymmetries in the year prior to option listings produce larger levels of option adoption. Additionally, I find that option introductions induce reductions in asymmetric information. I also report that option bid-ask spreads start from low initial levels with a tendency to increase over time, which is unexpected since the introduced options are initially illiquid; however, this can be explained by the low level of initial activity by informed agents.The second essay examines whether the dynamics of the implied volatility surface of equity options contain exploitable predictability patterns. The option pricing predictability is expected due to the learning behaviour of agents in option markets. In particular, I explore the possibility that the dynamics of the implied volatility surface of individual equity options may be associated with subsequent movements in the volatility surface implicit in S&P 500 index options. I present evidence of strong relationships in the cross-section and the dynamics between implied volatility surfaces of equity options and S&P 500 index options. Moreover, I show that the predictability patterns of equity options are better characterized by the incorporation of information from the recent dynamics in the implied volatility surface of S&P 500 index options. Additionally, I analyse the economic value of the equity option predictability through trading strategies using straddle and delta-hedged portfolios, which produce abnormal risk-adjusted returns.Finally in the third essay, I introduce an equilibrium model to explain predictability patterns in option pricing through the learning process followed by investors. In this model the unknown fundamental dividend growth rate is subject to breaks, where the time periods between breaks follow a memoryless stochastic process. Immediately after a break there is insufficient information to price option contracts accurately. Therefore, a representative Bayesian agent has to learn step by step as new information arrives regarding the new fundamental value. I show that learning makes beliefs time-varying, which produces dynamic biases in option prices and implied volatilities. In addition, I find that learning generates different dynamic impacts on option contracts across moneyness and time-to-maturity; and hence it induces dynamics on the implied volatility surface. Furthermore, similarly to the predictability features observable in option market data, learning mechanisms make the option pricing dynamics predictable.

With the rapid development of option markets throughout the world, option pricing has become an important field in financial engineering. Among a variety of option pricing models, volatility of underlying asset is associated with risk and uncertainty, and hence is treated as one of the key factors affecting the price of an option. In particular, in the framework of the Black-Scholes option pricing model, volatility of the underlying stock is the only unobservable variable, and has attracted a large amount of attention of both academics and practitioners. This thesis is concerned with the implied volatility in the Australian index option market. Two interesting problems are examined. First, the relation between implied volatility and subsequently realized volatility is investigated by using the S&P/ASX 200 (XJO) index options over a five-year period from April 2001 to March 2006. Unlike the S&P 100 index options in the US market, the XJO index options are traded infrequently, in low volumes, and with a long maturity cycle. This implies that the errors-in-variable problem for the measurement of implied volatility is more likely to exist. After accounting for this problem by the instrumental variable method, it is found that both call and put options implied volatilities are nearly unbiased and superior to historical volatility in forecasting future realized volatility. Second, the volatility structure implied by the XJO index options is examined during the period from April 2001 to June 2005. The volatility structure with respect to moneyness and time to maturity are investigated for both call and put option price series. It is found that the volatility smile largely exists, with call (put) option implied volatilities decreasing monotonically as the call (put) goes deeper out of the money (in the money). This result is consistent with the welldocumented evidence of volatility smile on other index options since the stock market crash of 1987. In summary, this thesis presents some important findings on the volatility inferred from the XJO index options traded on the ASX.