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

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  • Engle, Robert F

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.

Suggested Citation

  • Engle, Robert F, 1999. "Modeling the Impacts of Market Activity on Bid-Ask Spreads in the Option Market," University of California at San Diego, Economics Working Paper Series qt6rp7g17q, Department of Economics, UC San Diego.
  • Handle: RePEc:cdl:ucsdec:qt6rp7g17q
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    References listed on IDEAS

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    Cited by:

    1. Norden, Lars, 2003. "Asymmetric option price distribution and bid-ask quotes: consequences for implied volatility smiles," Journal of Multinational Financial Management, Elsevier, vol. 13(4-5), pages 423-441, December.
    2. Engle, Robert F. & Patton, Andrew J., 2004. "Impacts of trades in an error-correction model of quote prices," Journal of Financial Markets, Elsevier, vol. 7(1), pages 1-25, January.
    3. Guillaume, F., 2015. "The LIX: A model-independent liquidity index," Journal of Banking & Finance, Elsevier, vol. 58(C), pages 214-231.
    4. Ólan T. Henry & Michael McKenzie, 2006. "The Impact of Short Selling on the Price-Volume Relationship: Evidence from Hong Kong," The Journal of Business, University of Chicago Press, vol. 79(2), pages 671-692, March.
    5. João Amaro de Matos & Paula Antão, 2001. "Super-replicating Bounds on European Option Prices when the Underlying Asset is Illiquid," Economics Bulletin, AccessEcon, vol. 7(1), pages 1-7.
    6. Joao Amaro De Matos & Paula Antao, 2003. "Market illiquidity and bounds on European option prices," The European Journal of Finance, Taylor & Francis Journals, vol. 9(5), pages 475-498.
    7. Cao, Melanie & Wei, Jason, 2010. "Option market liquidity: Commonality and other characteristics," Journal of Financial Markets, Elsevier, vol. 13(1), pages 20-48, February.
    8. François-Heude, Alain & Yousfi, Ouidad, 2013. "On the liquidity of CAC 40 index options Market," MPRA Paper 47921, University Library of Munich, Germany, revised 01 Jul 2013.
    9. Sohnke M. Bartram & Frank R. Fehle, 2003. "Alternative Market Structures for Derivatives," Finance 0311007, University Library of Munich, Germany, revised 12 Dec 2003.
    10. Korn, Olaf & Krischak, Paolo & Theissen, Erik, 2017. "Illiquidity transmission from spot to futures markets," CFR Working Papers 14-10, University of Cologne, Centre for Financial Research (CFR).
    11. Saraoglu, Hakan & Louton, David & Holowczak, Richard, 2014. "Institutional impact and quote behavior implications of the options penny pilot project," The Quarterly Review of Economics and Finance, Elsevier, vol. 54(4), pages 473-486.
    12. Peter Christoffersen & Ruslan Goyenko & Kris Jacobs & Mehdi Karoui, 2011. "Illiquidity Premia in the Equity Options Market," CREATES Research Papers 2011-43, Department of Economics and Business Economics, Aarhus University.
    13. Wu, Wei-Shao & Liu, Yu-Jane & Lee, Yi-Tsung & Fok, Robert C.W., 2014. "Hedging costs, liquidity, and inventory management: The evidence from option market makers," Journal of Financial Markets, Elsevier, vol. 18(C), pages 25-48.
    14. Alain François-Heude & Ouidad Yous, 2014. "On the liquidity of CAC 40 index options Market," Working Papers 2014-445, Department of Research, Ipag Business School.
    15. 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.
    16. Sohnke M. Bartram & Frank R. Fehle, 2003. "Competition among Alternative Option Market Structures: Evidence from Eurex vs. Euwax," Finance 0307005, University Library of Munich, Germany, revised 06 Nov 2003.
    17. Collver, Charles, 2009. "Measuring the impact of option market activity on the stock market: Bivariate point process models of stock and option transactions," Journal of Financial Markets, Elsevier, vol. 12(1), pages 87-106, February.
    18. Anand, Amber, 2005. "Specialist: The firm or the individual?: Empirical evidence from the options markets," Journal of Economics and Business, Elsevier, vol. 57(6), pages 555-575.
    19. 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.

    More about this item

    Keywords

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

    JEL classification:

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

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