IDEAS home Printed from https://ideas.repec.org/a/cup/jfinqa/v59y2024i1p157-194_6.html
   My bibliography  Save this article

Derivatives and Market (Il)liquidity

Author

Listed:
  • Huang, Shiyang
  • Yueshen, Bart Z.
  • Zhang, Cheng

Abstract

We study how derivatives (with nonlinear payoffs) affect the underlying asset’s liquidity. In a rational expectations equilibrium, informed investors expect low conditional volatility and sell derivatives to the others. These derivative trades affect different 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.

Suggested Citation

  • Huang, Shiyang & Yueshen, Bart Z. & Zhang, Cheng, 2024. "Derivatives and Market (Il)liquidity," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 59(1), pages 157-194, February.
    • Handle: RePEc:cup:jfinqa:v:59:y:2024:i:1:p:157-194_6
    as

    Download full text from publisher

    File URL: https://www.cambridge.org/core/product/identifier/S0022109023000224/type/journal_article
    File Function: link to article abstract page
    Download Restriction: no
    ---><---

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:cup:jfinqa:v:59:y:2024:i:1:p:157-194_6. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no bibliographic references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Kirk Stebbing (email available below). General contact details of provider: https://www.cambridge.org/jfq .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.