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- Title
Derivatives and Market (Il)liquidity.
- Authors
Huang, Shiyang; Yueshen, Bart Z.; Zhang, Cheng
- Abstract
We study how derivatives (with nonlinear payoffs) affect the underlying asset's 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.
- Subjects
DERIVATIVE securities; LIQUIDITY (Economics); RISK premiums; RATIONAL expectations (Economic theory); ECONOMIC equilibrium; INFORMATION asymmetry; JACOBIAN matrices
- Publication
Journal of Financial & Quantitative Analysis, 2024, Vol 59, Issue 1, p157
- ISSN
0022-1090
- Publication type
Article
- DOI
10.1017/S0022109023000224