Settlement Procedures and Stock Market Efficiency

Abstract

Most markets that choose settlement day following expiration day select opening price rather than closing price as final settlement price (FSP) when index derivatives expire, while most markets that choose settlement day the same as expiration day select an average price rather than a single price as FSP. This study resolves this puzzle by exploring sources of expiration-day effects and investigates whether and how settlement procedures affect the trading in the underlying stock market at expiration of index derivatives. Four exogenous changes in TAIFEX settlement procedures provide us an excellent experimental ground to study the impact of the nature of settlement procedures on liquidity, market efficiency, and price discovery. We find market efficiency has the least reduction if FSP is determined by a single price, yet market efficiency is moved from the opening to pre-opening period if FSP is calculated by an average price. Moreover, we find a tradeoff between liquidity, market efficiency, and price discovery and manipulation prevention.

Keywords: Expiration-day effect, liquidity, market efficiency, price discovery, intraday seasonality, spillover, market depth

JEL Classification: G13, G14, G15