Implications of an Index-Contingent Trading Mechanism

Abstract

This paper analyzes a call market that enables conditioning not only on an asset price, but also on an index (a weighted average of stock prices) that is determined simultaneously with the prices of all assets. We compare two trading systems, with and without index-conditioning, and find that in the system with index-conditioning (i) traders indeed use the facility of index-conditioning, (ii) there is more "depth" (liquidity) in the market, (iii) price fluctuations around "true" values are lower, (iv) expected trading costs of liquidity traders are lower and (v) the expected utility of informed traders is lower than in a system without index-conditioning.

JEL Classification: G13, G14