Trading in Derivatives When the Underlying is Scarce
Kellogg School of Management - Department of Finance
Jeremy J. Graveline
University of Minnesota - Carlson School of Management
August 20, 2013
Regulatory restrictions and market frictions 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 also show that it is especially important to analyze 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: 50
Keywords: Scarcity, Short-selling, Price distortions, Derivatives, Regulation
JEL Classification: G12, G13
Date posted: November 20, 2011 ; Last revised: August 21, 2013
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