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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]
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Abstract

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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.

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