Trading in Derivatives When the Underlying is Scarce

50 Pages Posted: 20 Nov 2011 Last revised: 21 Aug 2013

Snehal Banerjee

University of California, San Diego (UCSD) - Rady School of Management

Jeremy J. Graveline

University of Minnesota - Carlson School of Management

Date Written: August 20, 2013

Abstract

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.

Keywords: Scarcity, Short-selling, Price distortions, Derivatives, Regulation

JEL Classification: G12, G13

Suggested Citation

Banerjee, Snehal and Graveline, Jeremy J., Trading in Derivatives When the Underlying is Scarce (August 20, 2013). Available at SSRN: https://ssrn.com/abstract=1961788 or http://dx.doi.org/10.2139/ssrn.1961788

Snehal Banerjee (Contact Author)

University of California, San Diego (UCSD) - Rady School of Management ( email )

9500 Gilman Drive
Rady School of Management
La Jolla, CA 92093
United States

Jeremy J. Graveline

University of Minnesota - Carlson School of Management ( email )

19th Avenue South
Minneapolis, MN 55455
United States
612-626-7817 (Phone)

HOME PAGE: http://www.tc.umn.edu/~jeremy/

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