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

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Young-Hye Cho
Robert F. Engle

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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 transactions data. We propose a new market microstructure theory which we call 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 the latter 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 find option market volume is not a significant determinant of option market spreads. This finding leads us to question the use of volume as a measure of liquidity and supports the derivative hedge 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. The fast market result would be predicted by the asymmetric information theory. Inventory model predicts big spreads in slow markets. Neither result would be observed if the underlying securities market provided a perfect hedge. We interpret these mixed results as meaning that the option market maker is able to only imperfectly hedge his positions in the underlying securities market. Our result of insignificant options volume casts doubt on the price discovery argument between stock and option market (Easley, O'Hara, and Srinivas (1998)). Asymmetric information costs in either market are naturally passed to the other market maker's hedgeing and therefore it is unimportant where the informed traders trade.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7331.

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Date of creation: Sep 1999
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Handle: RePEc:nbr:nberwo:7331

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G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies

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  1. 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:
  2. 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!]
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  3. 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!]
  4. 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)
  5. 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!]
  6. 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!]
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