Derivatives and Market (Il)liquidity

52 Pages Posted: 26 Dec 2018 Last revised: 11 May 2020

See all articles by Shiyang Huang

Shiyang Huang

The University of Hong Kong - Faculty of Business and Economics

Bart Z. Yueshen

INSEAD - Finance

Cheng Zhang

Victoria University of Wellington

Date Written: May 8, 2020

Abstract

We study how derivatives (with nonlinear payoffs) affect the liquidity of their underlying assets. In a
noisy rational expectations equilibrium, informed investors expect low conditional volatility and sell
derivatives to others. These derivative trades affect investors' utility differently, possibly amplifying
liquidity risk. As investors delta hedge their derivative positions, price impact in the underlying
drops, suggesting improved liquidity, because informed trading is diluted. In contrast, effects on
price reversal are ambiguous, depending on investors’ relative delta hedging sensitivity, i.e., the
gamma of the derivatives. The model cautions of potential disconnections between illiquidity
measures and liquidity risk premium due to derivatives trading.

Keywords: derivatives, options, liquidity risk premium, liquidity measure, price impact, price reversal

JEL Classification: G12, G13, G14

Suggested Citation

Huang, Shiyang and Yueshen, Bart Zhou and Zhang, Cheng, Derivatives and Market (Il)liquidity (May 8, 2020). Available at SSRN: https://ssrn.com/abstract=3296699 or http://dx.doi.org/10.2139/ssrn.3296699

Shiyang Huang

The University of Hong Kong - Faculty of Business and Economics ( email )

Pokfulam Road
Hong Kong
China

Bart Zhou Yueshen

INSEAD - Finance ( email )

Boulevard de Constance
F-77305 Fontainebleau Cedex
France

Cheng Zhang (Contact Author)

Victoria University of Wellington ( email )

P.O. Box 600
Wellington, 6140
New Zealand

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
114
Abstract Views
712
rank
263,546
PlumX Metrics