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Alternative Market Structures for Derivatives

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Author Info

  • Sohnke M. Bartram

    (Lancaster University)

  • Frank R. Fehle

    (University of South Carolina)

Abstract

In this paper, we compare option contracts from a traditional derivatives exchange to bank-issued options, also referred to as covered warrants, whose markets have grown rapidly around the world in recent years. While bank-issued option markets and traditional derivatives exchanges exhibit significant structural differences such as the absence of a central counterparty for bank-issued options, they frequently exist side-by-side, and the empirical evidence shows that there is significant overlap in their product offerings. We examine trading costs and liquidity in both markets and find that bank-issued options have smaller quoted percentage bid-ask spreads than traditional option contracts by an average of 4.3%. The bid-ask spread difference manifests itself in a highly regular fashion in that ask (bid) prices for bank-issued options are consistently higher than comparable ask (bid) prices for traditional option contracts. The difference of the bid prices is larger than the difference of the ask prices resulting in smaller bid-ask spreads for bank-issued options. The empirical analysis also indicates that bid-ask spreads in either market are lowered by competition from the other market. We present a potential explanation for the co-existence of the two market structures which suggests that the bank-issued option market caters more towards retail investors with predominantly speculative motives while traditional derivatives exchanges may cater more towards institutional investors with predominantly hedging motives.

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File URL: http://128.118.178.162/eps/fin/papers/0311/0311007.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0311007.

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Length: 47 pages
Date of creation: 13 Nov 2003
Date of revision: 12 Dec 2003
Handle: RePEc:wpa:wuwpfi:0311007

Note: Type of Document - PDF; prepared on IBM PC; pages: 47
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Web page: http://128.118.178.162

Related research

Keywords: Options; Market Design; Microstructure; Bid-Ask Spreads;

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References

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  1. Dietmar P.J. Leisen and Kenneth L. Judd, 2001. "A Partial Equilibrium Model of Option Markets," Computing in Economics and Finance 2001 219, Society for Computational Economics.
  2. Horst, J.R. ter & Veld, C.H., 2002. "Behavioral Preferences for Individual Securities: The Case for Call Warrants and Call Options," Discussion Paper 2002-95, Tilburg University, Center for Economic Research.
  3. Franke, Günter & Weber, Martin, 2003. "Heterogeneity of Investors and Asset Pricing in a Risk-Value World," CEPR Discussion Papers 3832, C.E.P.R. Discussion Papers.
  4. Chan, Howard Wei-Hong & Pinder, Sean M., 2000. "The value of liquidity: Evidence from the derivatives market," Pacific-Basin Finance Journal, Elsevier, vol. 8(3-4), pages 483-503, July.
  5. Young-Hye Cho & Robert F. Engle, 1999. "Modeling the Impacts of Market Activity on Bid-Ask Spreads in the Option Market," NBER Working Papers 7331, National Bureau of Economic Research, Inc.
  6. Barone-Adesi, Giovanni & Whaley, Robert E, 1987. " Efficient Analytic Approximation of American Option Values," Journal of Finance, American Finance Association, vol. 42(2), pages 301-20, June.
  7. Franke, Gunter & Stapleton, Richard C. & Subrahmanyam, Marti G., 1998. "Who Buys and Who Sells Options: The Role of Options in an Economy with Background Risk," Journal of Economic Theory, Elsevier, vol. 82(1), pages 89-109, September.
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Cited by:
  1. Koch, Alexander K. & Lazarov, Zdravetz, 2007. "The Trade-Off Between Liquidity and Precision of Position in Option Contracts," Review of Applied Economics, Review of Applied Economics, vol. 3(1-2).

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