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
Citation
HUANG, Shiyang; YUESHEN, Bart Zhou; and ZHANG, Cheng.
Derivatives and market (il)liquidity. (2024). Journal of Financial and Quantitative Analysis. 59, (1), 157-194.
Available at: https://ink.library.smu.edu.sg/lkcsb_research/7282
Copyright Owner and License
Authors
Creative Commons License
This work is licensed under a Creative Commons Attribution-NonCommercial-No Derivative Works 4.0 International License.
Additional URL
https://doi.org/10.1017/S0022109023000224