Determinants of Liquidity for Bank-Issued Options: Evidence from the Australian Covered Warrants Market
28 Pages Posted: 25 Aug 2008
Date Written: August 25, 2008
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: Suggested Citation