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Derivative Security Induced Price Manipulation

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  • Michael Gallmeyer
  • Duane Seppi

Abstract

This paper investigates the potential contribution of cash market price manipulation to an option's value. When the underlying's transaction price follows an exogeneous fundamental process plus a price impact component influenced by trade, both sides of an option position may try to move the underlying cash price. Optimal cash trading strategies consist of a manipulation component and a liquidity provision for the other traders in the market. When the price impact is transitory, the optimal cash strategy may involve ``pre-liquidation'' of manipulative cash trades to reduce trading costs. We find that cash market manipulation can represent a significant portion of an option's value. The price impact of manipulation can be non-monotonic and the optimal cash trading strategy can be discontinuous in the number of longs and shorts.

Suggested Citation

  • Michael Gallmeyer & Duane Seppi, "undated". "Derivative Security Induced Price Manipulation," GSIA Working Papers 2000-E41, Carnegie Mellon University, Tepper School of Business.
    • Handle: RePEc:cmu:gsiawp:415
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    File URL: http://www.tepper.cmu.edu/andrew/mg47/www/manip.pdf
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    References listed on IDEAS

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    1. Kumar, Praveen & Seppi, Duane J, 1992. "Futures Manipulation with "Cash Settlement."," Journal of Finance, American Finance Association, vol. 47(4), pages 1485-1502, September.
    2. Robert A. Jarrow, 2008. "Market Manipulation, Bubbles, Corners, and Short Squeezes," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 6, pages 105-130, World Scientific Publishing Co. Pte. Ltd..
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    5. Holthausen, Robert W. & Leftwich, Richard W. & Mayers, David, 1990. "Large-block transactions, the speed of response, and temporary and permanent stock-price effects," Journal of Financial Economics, Elsevier, vol. 26(1), pages 71-95, July.
    6. Robert A. Jarrow, 2008. "Derivative Security Markets, Market Manipulation, and Option Pricing Theory," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 7, pages 131-151, World Scientific Publishing Co. Pte. Ltd..
    7. Hasbrouck, Joel, 1991. "The Summary Informativeness of Stock Trades: An Econometric Analysis," The Review of Financial Studies, Society for Financial Studies, vol. 4(3), pages 571-595.
    8. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    9. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
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    Cited by:

    1. Ulrich Horst & Felix Naujokat, 2008. "Illiquidity and Derivative Valuation," Papers 0901.0091, arXiv.org.

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