Determinants of Liquidity for Bank-Issued Options: Evidence from the Australian Covered Warrants Market

28 Pages Posted: 25 Aug 2008

See all articles by Giovanni Petrella

Giovanni Petrella

Università Cattolica del Sacro Cuore

Reuben Segara

University of Sydney Business School; Financial Research Network (FIRN)

Date Written: August 25, 2008

Abstract

In this paper, we apply a structural model to investigate the main determinants of the bid-ask spread for Australian covered warrants. These instruments are also referred to as bank-issued options. They have been mainly promoted to retail investors, and have attracted the interest of market practitioners and academics, based upon their tremendous growth in trading volume across several stock exchanges. Three main determinants are found that significantly contribute to the size of the warrant bid-ask spread. The first two determinants relate to the inventory risk management practices of market makers and include the initial cost of setting up a delta neutral portfolio, as well as rebalancing costs to keep the portfolio delta neutral. This particular result validates that the spread of warrants are positively related to the spread of the underlying asset. The last determinant relates to adverse selection costs, where market makers incorporate a reservation bid-ask spread to protect themselves from scalpers. No evidence is found to show that a higher level of market competition among warrant issuers leads to a narrower warrant spread.

Keywords: covered warrants, options, liquidity, bid-ask spread

JEL Classification: G10, G20, G24

Suggested Citation

Petrella, Giovanni and Segara, Reuben, Determinants of Liquidity for Bank-Issued Options: Evidence from the Australian Covered Warrants Market (August 25, 2008). 21st Australasian Finance and Banking Conference 2008 Paper. Available at SSRN: https://ssrn.com/abstract=1253168 or http://dx.doi.org/10.2139/ssrn.1253168

Giovanni Petrella

Università Cattolica del Sacro Cuore ( email )

Largo Gemelli 1
Milano, 20123
Italy
+39 02 72343007 (Phone)

Reuben Segara (Contact Author)

University of Sydney Business School ( email )

Sydney
Australia
+61 2 9351 8790 (Phone)
+61 2 9351 6461 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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