Options Trading and the Cost of Debt

Abstract

Equity option markets can have a dual effect on firm's' cost of debt. On one hand, options attract more informed investors that increase price informativeness and reduce information asymmetries in the market, facilitating firm financing. On the other, by attracting more informed investors that provide reassurance to managerial career concerns, options can increase the potential for risk-shifting in firms. We explore these two channels via different tests on corporate bond yields, and use different econometric specifications including quasi-natural experiments to mitigate endogeneity concerns. We find evidence consistent with the presence of both channels. Risk-shifting seems to dominate when private benefits from risk-taking are high enough.

Keywords: cost of debt, options trading, risk-shifting, price informativeness

JEL Classification: G12, G23, G24, G30, G31