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Modeling the Impacts of Market Activity on Bid-Ask Spreads in the Option Market

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Author Info
Robert Engle (New York University)

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Abstract

In this paper, we examine the impact of market activity on the percentage bid-ask spreads of S&P 100 index options using transaction data. We propose a new market microstructure theory called a derivative hedge theory, in which option market percentage spreads will be inversely related to the option market maker's ability to hedge his positions in the underlying market, as measured by the liquidity of this underlying market. In a perfect hedge world, spreads arise from the illiquidity of the underlying market, rather than from inventory risk or informed trading in the option market itself. We estimate three models to investigate various market microstructure theories. In the static model, option spreads are a function of moneyness, time to maturity, option prices, hedge ratios and volatility. The dynamic model includes time between trades or duration and average volume per transaction while the cross-market model adds cross option market activity and spreads in the underlying market. We find option market volume is not a significant determinant of option market spreads, which challenges the validity of volume as a proxy for liquidity and supports my theory. Option market spreads are positively related to spreads in the underlying market, again supporting our theory. However, option market duration does affect option market spreads, with very slow and very fast option markets both leading to bigger spreads. Only the fast market result would be predicted by asymmetric information theory. Inventory models predict big spreads in slow markets. Neither would be observed if the underlying securities market provided a perfect hedge. We interpret these mixed results to mean that the option market maker is able to only imperfectly hedge his positions in the underlying securities market. Our result of insignificant option volume casts doubt on the price discovery argument between stock and option markets (Easley, O'Hara, and Srinivas (1997)). Asymmetric information costs in either market are naturally passed to the other market by market maker's hedging and therefore it is unimportant where the informed traders trade.

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Paper provided by Department of Economics, UC San Diego in its series University of California at San Diego, Economics Working Paper Series with number 1999-05.

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Date of creation: 01 Feb 1999
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Handle: RePEc:cdl:ucsdec:1999-05

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Keywords: derivative hedge; market microstructure; liquidity; bid-ask spreads; S&P 100 index options market; asymmetric information;

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  15. Anat R. Admati, Paul Pfleiderer, 1988. "A Theory of Intraday Patterns: Volume and Price Variability," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 1(1), pages 3-40. [Downloadable!] (restricted)
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  17. Bhattacharya, Mihir, 1987. "Price Changes of Related Securities: The Case of Call Options and Stocks," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 22(01), pages 1-15, March. [Downloadable!]
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  24. Stoll, Hans R, 1989. " Inferring the Components of the Bid-Ask Spread: Theory and Empirical Tests," Journal of Finance, American Finance Association, vol. 44(1), pages 115-34, March. [Downloadable!] (restricted)
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Paul D. McNelis & Carrie K.C. Chan, 2004. "Deflationary Dynamics in Hong Kong: Evidence from Linear and Neural Network Regime Switching Models," Working Papers 212004, Hong Kong Institute for Monetary Research. [Downloadable!]
  2. Robert Engle & Andrew Patton, 2000. "Impacts of Trades in an Error-Correction Model of Quote Prices," University of California at San Diego, Economics Working Paper Series 2000-26, Department of Economics, UC San Diego. [Downloadable!]
    Other versions:
  3. Olan T. Henry & Michael McKenzie, 2004. "The Impact of Short Selling on the Price-Volume Relationship: Evidence from Hong Kong," Working Papers 032004, Hong Kong Institute for Monetary Research. [Downloadable!]
    Other versions:
  4. João Amaro de Matos & Paula Antão, 2001. "Super-replicating Bounds on European Option Prices when the Underlying Asset is Illiquid," Economics Bulletin, Economics Bulletin, vol. 7, pages 1-7. [Downloadable!]
  5. Matos, Joao Amaro de & Antao, Paula, 2000. "Market Illiquidity and the Bid-Ask Spread of Derivatives," FEUNL Working Paper Series wp386, Universidade Nova de Lisboa, Faculdade de Economia. [Downloadable!]
  6. João Amaro De Matos & Paula Antão, 2003. "Market illiquidity and bounds on European option prices," European Journal of Finance, Taylor and Francis Journals, vol. 9(5), pages 475-498, October. [Downloadable!] (restricted)
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