Trading in Derivatives When the Underlying is Scarce
Northwestern University - Kellogg School of Management - Department of Finance
Jeremy J. Graveline
University of Minnesota - Carlson School of Management
June 13, 2013
Regulatory restrictions and market frictions, such as transactions costs, search costs, short-sales constraints and margin requirements, can constrain the aggregate quantity of long and short positions in a security. When these constraints bind, we refer to the security as scarce, and its price becomes distorted relative to its value in a frictionless market. We show that an otherwise redundant derivative can reduce the price distortion of the underlying security by relaxing its scarcity. We show that even simple derivatives on a scarce security are not redundant and can reduce the price distortion by relaxing the scarcity of the underlying.We also show that it is especially important to analyze the equilibria in the underlying and derivative markets jointly when evaluating the impact of regulation, such as short-sales bans and position limits in derivatives, that restricts trade.
Number of Pages in PDF File: 44
Keywords: Scarcity, Short-selling, Price distortions, Derivatives, Regulation
JEL Classification: G12, G13working papers series
Date posted: November 20, 2011 ; Last revised: June 13, 2013
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