Liquidity and price discovery in derivatives markets

Abstract

This dissertation investigates the economics of liquidity and price discovery in derivatives markets. The importance of these issues is underscored by the increasing prevalence of derivatives worldwide in recent decades. As both benefits and harms of derivatives to capital markets can be substantial, it is essential to understand the fundamentals of the markets for derivatives. Each essay addresses a research question with scarce or conflicting prior research findings to provide evidence which can assist investors, regulators, and academics to understand the microstructure of derivatives markets. The first issue examined in this dissertation is the impact of reducing the contract size threshold for off-market trading on liquidity in an options market. This dissertation finds evidence that the reduction in the minimum contract size thresholds for off­market trading lowers percentage effective spreads for small-to-medium trades. In addition, the distribution of quoted depth is affected by the recent rule change, becoming less positively skewed. Results indicate that small-to-medium trades incur lower transaction costs; however, large trades that are executed on the central limit order book do not benefit from the structural transition. Market makers compete on better terms for small-to-medium order flow after the event, while offering less attractive trade terms to large traders. Results also suggest that market makers compete more aggressively for small-to-medium trades and quote mid-size depths more often. The second issue examined is the impact of introducing a pure pro-rata algorithm on the liquidity of the market for Euribor futures contracts on NYSE LIFFE. Results indicate that the Euribor market experiences deterioration in liquidity: (I) both best and total depth fall and (2) quoted spreads widen after the structural change. Results also reveal that the Euribor market becomes more active after the event; both trading volume and trade frequency increase substantially after the event. Finally, after the transition, liquidity demanders are more likely to submit smaller market orders. The reduction in depth and increase in quoted spreads suggest that liquidity demanders incur higher trade execution costs after the transition. In contrast, the transition ts beneficial for the exchange since trading volume is higher under the new regime. The third issue examined is the impact of option introduction on informed trading in the underlying market. This dissertation adds to the literature by: (I) examining listings of both exchange traded options (ETOs) and Flex options, which are yet to be investigated in the literature and (2) investigating how the introduction of options affects informed trading using a more direct measure of the probability of informed trading (PIN) than those used in prior research. Results indicate that the liquidity of the underlying market is not affected by option listings. Results of the PIN test suggest that informed traders do not move to the options market upon the introduction of both types of options. These findings support the results in prior research that informed traders' choice of trading venues is multidimensional. The final issue examined in this dissertation is the informational role of market makers in the S&P/ ASX 200 CFD (CFD 200) market relative to other alternative index markets. Results reveal that the market for the SPI 200 Index Futures (SPI 200)contracts plays a dominant role in the process of price discovery in the S&P/ASX 200 index market. The remaining contributions to price discovery are shared between the CFD 200 and ETF markets; between the two markets, the contribution of the CFD 200 market is substantially greater than that of the S&P/ASX 200 ETF. This dissertation also provides evidence that innovation correlations between the CFD 200 and SPI 200 markets are considerably larger than those between index-linked instruments reported in prior studies. This may imply that the CFD 200 market makers mechanically set quotes - "autoquoting" - using limit order prices from the SPI 200 as benchmark quotes.