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Margin Rules, Informed Trading in Derivatives and Price Dynamics

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  • K. John
  • A. Koticha
  • R. Narayanan

Abstract

We analyze the impact of option trading and margin rules on the behavior of informed traders and on the microstructure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock's bid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock margins and options margins (relative to stock margins) are sufficiently large or small but not when they are of moderate size.

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  • K. John & A. Koticha & R. Narayanan, "undated". "Margin Rules, Informed Trading in Derivatives and Price Dynamics," New York University, Leonard N. Stern School Finance Department Working Paper Seires 99-047, New York University, Leonard N. Stern School of Business-.
  • Handle: RePEc:fth:nystfi:99-047
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    File URL: http://www.stern.nyu.edu/fin/workpapers/papers99/wpa99047b.pdf
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    References listed on IDEAS

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    1. Hsieh, David A & Miller, Merton H, 1990. " Margin Regulation and Stock Market Volatility," Journal of Finance, American Finance Association, vol. 45(1), pages 3-29, March.
    2. Hardouvelis, Gikas A, 1990. "Margin Requirements, Volatility, and the Transitory Components of Stock Prices," American Economic Review, American Economic Association, vol. 80(4), pages 736-762, September.
    3. Grossman, Sanford J, 1988. "An Analysis of the Implications for Stock and Futures Price Volatility of Program Trading and Dynamic Hedging Strategies," The Journal of Business, University of Chicago Press, vol. 61(3), pages 275-298, July.
    4. Seguin, Paul J., 1990. "Stock volatility and margin trading," Journal of Monetary Economics, Elsevier, vol. 26(1), pages 101-121, August.
    5. Chowdhry, Bhagwan & Nanda, Vikram, 1998. "Leverage and Market Stability: The Role of Margin Rules and Price Limits," The Journal of Business, University of Chicago Press, vol. 71(2), pages 179-210, April.
    6. Back, Kerry, 1993. "Asymmetric Information and Options," Review of Financial Studies, Society for Financial Studies, vol. 6(3), pages 435-472.
    7. Milgrom, Paul & Stokey, Nancy, 1982. "Information, trade and common knowledge," Journal of Economic Theory, Elsevier, vol. 26(1), pages 17-27, February.
    8. Kyle, Albert S, 1985. "Continuous Auctions and Insider Trading," Econometrica, Econometric Society, vol. 53(6), pages 1315-1335, November.
    9. David Easley & Maureen O'Hara & P.S. Srinivas, 1998. "Option Volume and Stock Prices: Evidence on Where Informed Traders Trade," Journal of Finance, American Finance Association, vol. 53(2), pages 431-465, April.
    10. Biais, Bruno & Hillion, Pierre, 1994. "Insider and Liquidity Trading in Stock and Options Markets," Review of Financial Studies, Society for Financial Studies, vol. 7(4), pages 743-780.
    11. Skinner, Douglas J., 1989. "Options markets and stock return volatility," Journal of Financial Economics, Elsevier, vol. 23(1), pages 61-78, June.
    12. Fedenia, Mark & Grammatikos, Theoharry, 1992. "Options Trading and the Bid-Ask Spread of the Underlying Stocks," The Journal of Business, University of Chicago Press, vol. 65(3), pages 335-351, July.
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    Cited by:

    1. de Jong, Cyriel & Koedijk, Kees & Schnitzlein, Charles, 2002. "Stock Market Quality in the Prescence of a Traded Option," CEPR Discussion Papers 3173, C.E.P.R. Discussion Papers.

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