Options Trading and Corporate Debt Structure

Abstract

Recent empirical studies find that increased informational efficiency associated with options trading activity enhances firm value by allowing for a more efficient allocation of firm resources. In this paper, we develop and test the hypothesis that, in addition to a more efficient allocation of firm resources, options trading also enhances firm value through a financing channel, by promoting a lower cost debt structure that relies more on public debt and less on more costly bank financing. Consistent with both an information channel (where increased informational efficiency facilitates public debt issuance and reduces demand for the superior ability of banks to access and process private information) and a governance channel (where enhanced informational efficiency improves the effectiveness of alternative governance thereby reducing demand for bank lender governance), we find that options trading leads firms to shift from bank loans to public bonds. Consistent with an information channel effect, we show that the reduced reliance on bank borrowing is concentrated in high information asymmetry firms that are expected to benefit more from the enhanced information environment associated with options trading activity. Consistent with a governance channel effect, we find a more negative relation between options trading activity and bank borrowing in competitive industries where external governance pressure is high. In addition, we find that loan covenant strictness decreases with increases in options trading volume. Overall, our findings suggest that enhanced information efficiency associated with options trading lowers financing costs by reducing firm demand for the unique informational and governance qualities associated with bank borrowing.

Keywords: Options trading, debt structure, new debt choice, information asymmetry

JEL Classification: G13, G12, G32, G34