Publication Type

Journal Article

Version

submittedVersion

Publication Date

1-2024

Abstract

We study how derivatives (with nonlinear payoffs) affect the underlying assets liquidity. In a rational expectations equilibrium, informed investors expect low conditional volatility and sell derivatives to the others. These derivative trades affect different investors utility differently, possibly amplifying liquidity risk. As investors delta hedge their derivative positions, price impact in the underlying drops, suggesting improved liquidity, because informed trading is diluted. In contrast, effects on price reversal are ambiguous, depending on investors relative delta hedging sensitivity, i.e., the gamma of the derivatives. The model cautions of potential disconnections between illiquidity measures and liquidity risk premium due to derivatives trading.

Keywords

derivatives, liquidity measure, liquidity risk premium, options, price impact, price reversal

Discipline

Finance and Financial Management | Portfolio and Security Analysis

Research Areas

Finance

Publication

Journal of Financial and Quantitative Analysis

Volume

59

Issue

1

First Page

157

Last Page

194

ISSN

0022-1090

Identifier

10.1017/S0022109023000224

Publisher

Cambridge University Press

Copyright Owner and License

Authors

Additional URL

https://doi.org/10.1017/S0022109023000224

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