Too many options? Theory and evidence on option exchange design

A model of option exchange design is proposed and tested. The model allows investors to choose among several exchange‐traded options based on a trade‐off between standardization costs and liquidity/transaction costs. It employs a spatial economics approach to provide results for the existence of markets for particular option contracts on the exchange, a comparison of exchange design by a social planner and a profit‐maximizing monopolist (corresponding to the idea that most derivatives exchanges centralize the design and creation of option contracts), and comparative statics that can potentially aid decision makers in the design of option exchanges. In the empirical work, open interest is analyzed for Chicago Board Options Exchange (CBOE) options on the stocks in the S&P 100 index. In accordance with the model's predictions, open interest forms a previously undocumented seesaw pattern across strike prices, clustering around certain strike prices, and dropping off for the adjacent strike prices. © 2006 Wiley Periodicals, Inc. Jrl Fut Mark 26:533–570, 2006