Do Derivatives Matter? Evidence from a Policy Experiment

Abstract

We study the impact of derivatives on stock characteristics such as valuation, price efficiency, and liquidity. We resolve the endogeneity issue faced in the extant literature by using an order issued by the Indian market regulator that resulted in delisting of 51 stocks from the derivative segment. Using this policy experiment, we examine the conflicting hypothesis regarding the impact of derivatives on stock fundamentals. We find that excluded firms underperform the market by 4.07% during the event window. We identify decline in price efficiency and reduction in liquidity as channels through which the above phenomenon manifests. Contrary to the expectations of the regulators, volatility largely remains unchanged. We rule out regulatory targeting by employing several placebo and other robustness tests. We conclude that derivatives indeed add value by improving price efficiency and liquidity of a stock.

Keywords: Derivative, Short sell constraint, Market efficiency, Market integrity

JEL Classification: G12, G14