Hostname: page-component-cd9895bd7-8ctnn Total loading time: 0 Render date: 2024-12-27T23:03:46.308Z Has data issue: false hasContentIssue false
  • English
  • Français

Derivatives and Market (Il)liquidity

Published online by Cambridge University Press:  14 March 2023

Shiyang Huang ,
Bart Z. Yueshen  and
Cheng Zhang
Shiyang Huang
Affiliation:
The University of Hong Kong Faculty of Business and Economics [email protected]
Bart Z. Yueshen
Affiliation:
INSEAD [email protected]
Cheng Zhang*
Affiliation:
University of Denver Daniels College of Business [email protected] (corresponding author)
*
[email protected]
Rights & Permissions [Opens in a new window]

Abstract

Core share and HTML view are not available for this content. However, as you have access to this content, a full PDF is available via the ‘Save PDF’ action button.

We study how derivatives (with nonlinear payoffs) affect the underlying asset’s liquidity. In a rational expectations equilibrium, informed investors expect low conditional volatility and sell derivatives to the others. These derivative trades affect different investors’ utility differently, possibly amplifying liquidity risk. As investors delta hedge their derivative positions, price impact in the underlying drops, suggesting improved liquidity, because informed trading is diluted. In contrast, effects on price reversal are ambiguous, depending on investors’ relative delta hedging sensitivity (i.e., the gamma of the derivatives). The model cautions of potential disconnections between illiquidity measures and liquidity risk premium due to derivatives trading.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 59 , Issue 1 , February 2024 , pp. 157 - 194
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

We thank an anonymous reviewer, Hendrik Bessembinder (the editor), Ulf Axelson, Francisco Barillas,Peter Bossaerts, Georgy Chabakauri, David Cimon, Jared Delisle, Bernard Dumas, Lew Evans, Sergei Glebkin, Naveen Gondhi, Bruce Grundy, Jianfeng Hu, Christian Julliard, Péter Kondor, Igor Makarov, Ian Martin, Massimo Massa, Mick Swartz, Andrea Tamoni, Bart Taub, Wing Wah Tham, Jos van Bommel, Dimitri Vayanos, Grigory Vilkov, Ulf von Lilienfeld-Toal, Jiang Wang, Qinghai Wang, Robert Webb, Liyan Yang, and Zhuo Zhong for their invaluable insights and suggestions. In addition, comments and feedback are greatly appreciated from participants at conferences and seminars at the 2016 Derivative Markets Conference, 2016 Portsmouth-Fordham Conference on Banking & Finance, 2019 Erasmus Liquidity Conference, Luxembourg School of Finance, University of Adelaide, University of Bristol, University of Exeter, University of Melbourne, University of New South Wales, and Victoria University of Wellington. There are no competing financial interests that might be perceived to influence the analysis, the discussion, and/or the results of this article. All errors are our own.

References

Acharya, V. V., and Pedersen, L. H.. “Asset Pricing with Liquidity Risk.” Journal of Financial Economics, 77 (2005), 375–410.CrossRefGoogle Scholar
Albagli, E.; Hellwig, C.; and Tsyvinski, A.. “Information Aggregation with Asymmetric Asset Payoffs.” Journal of Finance, forthcoming (2024).Google Scholar
Amihud, Y. “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects.” Journal of Financial Markets, 5 (2002), 31–56.CrossRefGoogle Scholar
Amihud, Y. “Illiquidity and Stock Returns: A Revisit.” Critical Finance Review, 8 (2019), 203–221.CrossRefGoogle Scholar
Amihud, Y.; Mendelson, H.; and Pedersen, L. H.. “Liquidity and Asset Prices.” In Foundations and Trends in Finance, Vol. 1, Constantinides, G. M., Allen, F., Lo, A. W., and Stulz, R. M., eds. Delft, Netherlands: Now Publishers (2005), 269–364.Google Scholar
Barbon, A., and Buraschi, A.. “Gamma Fragility.” Working Paper, University of St. Gallen (2019).CrossRefGoogle Scholar
Barlevy, G., and Veronesi, P.. “Rational Panics and Stock Market Crashes.” Journal of Economic Theory, 110 (2003), 234–263.CrossRefGoogle Scholar
Ben-Rephael, A.; Kadan, O.; and Whol, A.. “The Diminishing Liquidity Premium.” Journal of Financial and Quantitative Analysis, 50 (2015), 197–229.CrossRefGoogle Scholar
Bernardo, A. E., and Judd, K. L.. “Asset Market Equilibrium with General Tastes, Returns, and Informational Asymmetries.” Journal of Financial Markets, 3 (2000), 17–43.CrossRefGoogle Scholar
Biais, B.; Bossaerts, P.; and Spatt, C.. “Equilibrium Asset Pricing and Portfolio Choice Under Asymmetri Information.” Review of Financial Studies, 23 (2010), 1503–1543.CrossRefGoogle Scholar
Biais, B., and Hillion, P.. “Insider and Liquidity Trading in Stock and Options Markets.” Review of Financial Studies, 7 (1994), 743–780.CrossRefGoogle Scholar
Branch, B., and Finnerty, J. E.. “The Impact of Option Listing on the Price and Volume of the Underlying Stock.” Financial Review, 16 (1981), 1–15.Google Scholar
Brennan, M. J., and Cao, H. H.. “Information, Trade, and Derivative Securities.” Review of Financial Studies, 9 (1996), 163–208.CrossRefGoogle Scholar
Brennan, M. J., and Subrahmanyam, A.. “Market Microstructure and Asset Pricing: On the Compensation for Illiquidity in Stock Returns.” Journal of Financial Economics, 41 (1996), 441–464.CrossRefGoogle Scholar
Breon-Drish, B. “On Existence and Uniqueness of Equilibrium in a Class of Noisy Rational Expectations Models.” Review of Economic Studies, 82 (2015), 868–921.CrossRefGoogle Scholar
Campbell, J. Y.; Grossman, S. J.; and Wang, J.. “Trading Volume and Serial Correlation in Stocks Returns.” Quarterly Journal of Economics, 108 (1993), 905–939.CrossRefGoogle Scholar
Cao, H. H. “The Effect of Derivative Assets on Information Acquisition and Price Behavior in a Rational Expectations Equilibrium.” Review of Financial Studies, 12 (1999), 131–163.CrossRefGoogle Scholar
Chabakauri, G.; Yuan, K.; and Zachariadis, K.. “Multi-Asset Noisy Rational Expectations Equilibrium with Contingent Claims.” Review of Economic Studies, 89 (2022), 2445–2490.CrossRefGoogle Scholar
Collin-Dufresne, P., and Fos, V.. “Do Prices Reveal the Presence of Informed Trading?” Journal of Finance, 70 (2015), 1555–1582.CrossRefGoogle Scholar
Conrad, J. “The Price Effect of Option Introduction.” Journal of Finance, 44 (1989), 487–498.CrossRefGoogle Scholar
Critical Finance Review, Vol. 8, Ivo Welch, ed. Delft, Netherlands: Now Publisher (2019).Google Scholar
Damodaran, A., and Lim, J.. “The Effects of Option Listing on the Underlying Stocks’ Return Process.” Journal of Banking & Finance, 15 (1991), 647–664.CrossRefGoogle Scholar
Danielsen, B. R., and Sorescu, S. M.. “Why Do Option Introductions Depress Stock Prices? A Study of Diminishing Short Sale Constraints.” Journal of Financial and Quantitative Analysis, 36 (2001), 451–484.CrossRefGoogle Scholar
Detemple, J., and Jorion, P.. “Option Listing and Stock Returns: An Empirical Analysis.” Journal of Banking and Finance, 14 (1990), 781–801.CrossRefGoogle Scholar
Dow, J. “Arbitrage, Hedging, and Financial Innovation.” Review of Financial Studies, 11 (1998), 739–755.CrossRefGoogle Scholar
Drienko, J.; Smith, T.; and von Reibnitz, A.. “A Review of the Return–Illiquidity Relationship.” Critical Finance Review, 8 (2019), 127–171.CrossRefGoogle Scholar
Easley, D.; O’Hara, M.; and Srinivas, P. S.. “Option Volume and Stock Prices: Evidence on Where Informed Traders Trade.” Journal of Finance, 53 (1998), 431–465.CrossRefGoogle Scholar
Fedenia, M., and Grammatikos, T.. “Options Trading and the Bid–Ask Spread of the Underlying Stocks.” Journal of Business, 65 (1992), 335–351.CrossRefGoogle Scholar
Gao, F., and Wang, J.. “The Market Impact of Options.” Working Paper, Tsinghua University (2017).CrossRefGoogle Scholar
Gârleanu, N.; Pedersen, L. H.; and Poteshman, A. M.. “Demand-Based Option Pricing.” Review of Financial Studies, 22 (2009), 4259–4299.CrossRefGoogle Scholar
Glosten, L. R., and Harris, L. E.. “Estimating the Components of the Bid–Ask Spread.” Journal of Financial Economics, 21 (1988), 123–142.CrossRefGoogle Scholar
Grossman, S. J., and Miller, M. H.. “Liquidity and Market Structure.” Journal of Finance, 43 (1988), 617–633.CrossRefGoogle Scholar
Grossman, S. J., and Stiglitz, J. E.. “On the Impossibility of Informationally Efficient Markets.” American Economic Review, 70 (1980), 393–408.Google Scholar
Han, B. Y. “Dynamic Information Acquisition and Asset Prices.” Working Paper, University of Maryland (2018).Google Scholar
Harris, L., and Amato, A.. “Illiquidity and Stock Returns: Cross-Section and Time-Series Effects: A Replication.” Critical Finance Review, 8 (2019), 173–202.CrossRefGoogle Scholar
Hasbrouck, J. “Trading Costs and Returns for U.S. Equities: Estimating Effective Costs from Daily Data.” Journal of Finance, 64 (2009), 1445–1477.CrossRefGoogle Scholar
Hu, J. “Option Listing and Information Asymmetry.” Review of Finance, 22 (2017), 1153–1194.CrossRefGoogle Scholar
Huang, S. “The Effects of Options on Information Acquisition and Asset Pricing.” Working Paper, University of Hong Kong (2015).CrossRefGoogle Scholar
Kumar, R.; Sarin, A.; and Shastri, K.. “The Impact of Index Options on the Underlying Stocks: The Evidence from the Listing of Nikkei Stock Average Options.” Pacific-Basin Finance Journal, 3 (1995), 303–317.CrossRefGoogle Scholar
Kumar, R.; Sarin, A.; and Shastri, K.. “The Impact of Options Trading on the Market Quality of the Underlying Security: An Empirical Analysis.” Journal of Finance, 53 (1998), 717–732.CrossRefGoogle Scholar
Kyle, A. S. “Continuous Auctions and Insider Trading.” Econometrica, 53 (1985), 1315–1336.CrossRefGoogle Scholar
Li, H.; Novy-Marx, R.; and Velikov, M.. “Liquidity Risk and Asset Pricing.” Critical Finance Review, 8 (2019), 223–255.CrossRefGoogle Scholar
Llorente, G.; Michaely, R.; Saar, G.; and Wange, J.. “Dynamic Volume-Return Relation of Individual Stocks.” Review of Financial Studies, 15 (2002), 1005–1047.CrossRefGoogle Scholar
Malamud, S. “Noisy Arrow-Debreau Equilibria.” Working Paper, Swiss Finance Institute (2015).CrossRefGoogle Scholar
Marín, J. M., and Rahi, R.. “Speculative Securities.” Economic Theory, 14 (1999), 653–668.Google Scholar
Massa, M. “Financial Innovation and Information: The Role of Derivatives When a Market for Information Exists.” Review of Financial Studies, 15 (2002), 927–957.CrossRefGoogle Scholar
Mayhew, S., and Mihov, V. T.. “Another Look at Option Listing Effects.” Working Paper, Texas Christian University (2000).Google Scholar
Mayhew, S., and Mihov, V. T.. “How Do Exchanges Select Stocks for Option Listing?” Journal of Finance, 59 (2004), 447–471.CrossRefGoogle Scholar
Mixon, S., and Onur, E.. “Volatility Derivatives in Practice: Activity and Impact.” Working Paper, Commodity Futures Trading Commission (2014).CrossRefGoogle Scholar
Ni, S. X.; Pearson, N. D.; and Poteshman, A. M.. “Stock Price Clustering on Option Expiration Dates.” Journal of Financial Economics, 78 (2005), 49–87.Google Scholar
Ni, S. X.; Pearson, N. D.; Poteshman, A. M.; and White, J.. “Does Option Trading Have a Pervasive Impact on Underlying Stock Prices?” Review of Financial Studies, 34 (2021), 1952–1986.CrossRefGoogle Scholar
Pástor, Ľ., and Stambaugh, R. F.. “Liquidity Risk and Expected Returns.” Journal of Political Economy, 111 (2003), 642–685.CrossRefGoogle Scholar
Pástor, Ľ., and Stambaugh, R. F.. “Liquidity Risk After 20 Years.” Critical Finance Review, 8 (2019), 277–299.CrossRefGoogle Scholar
Pontiff, J., and Singla, R.. “Liquidity Risk?” Critical Finance Review, 8 (2019), 257–276.CrossRefGoogle Scholar
Roll, R. “A Simple Implicit Measure of the Effective Bid–Ask Spread in an Efficient Market.” Journal of Finance, 39 (1984), 1127–1139.Google Scholar
Sadka, R. “Momentum and Post-Earnings-Announcement Drift Anomalies: The Role of Liquidity Risk.” Journal of Financial Economics, 80 (2006), 309–349.CrossRefGoogle Scholar
Smith, K. “Financial Markets with Trade on Risk and Return.” Review of Financial Studies, 32 (2019), 4042–4078.CrossRefGoogle Scholar
Sorescu, S. M. “The Effect of Options on Stock Prices: 1973 to 1995.” Journal of Finance, 55 (2000), 487–514.CrossRefGoogle Scholar
Vayanos, D., and Wang, J.. “Liquidity and Asset Returns Under Asymmetric Information and Imperfect Competition.” Review of Financial Studies, 25 (2012), 1339–1365.CrossRefGoogle Scholar
Vayanos, D., and Wang, J.. “Chapter 19: Market Liquidity—Theory and Empirical Evidence.” In Handbook of the Economics of Finance, Vol. 2, Constantinides, G. M., Harris, M., and Stulz, R. M., eds. Boston, MA: Elsevier (2013), 1289–1361.Google Scholar
Supplementary material: PDF

Huang et al. supplementary material

Huang et al. supplementary material

Download Huang et al. supplementary material(PDF)
PDF 198.4 KB