Derivatives and market (il)liquidity

• Main Authors: HUANG, Shiyang, YUESHEN, Bart Zhou, ZHANG, Cheng
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2024
• Subjects: derivatives; liquidity measure; liquidity risk premium; options; price impact; price reversal; Finance and Financial Management; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/lkcsb_research/7282; https://ink.library.smu.edu.sg/context/lkcsb_research/article/8281/viewcontent/DerivativesMarketilliq_sv.pdf
• Institution: Singapore Management University

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.