The Impact of Derivatives on Cash Market

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The Impact of Derivatives on Cash Markets: What Have We Learned?
Stewart Mayhew Department of Banking and Finance Terry College of Business University of Georgia Athens, GA 30602-6253 October 27, 1999 Revised: February 3, 2000

The Impact of Derivatives on Cash Markets: What Have We Learned?

Abstract This paper summarizes the theoretical and empirical research on how the introduction of derivative securities affects the underlying market. A wide array of theoretical approaches has been applied to the question of how speculative trading, the introduction of futures, or the introduction of options might affect the stability, liquidity and price informativeness of asset markets. In most cases, the resulting models predict that speculative trading and derivative markets stabilize the underlying market under certain restrictive conditions, but in general the predictions can go either way, depending on parameter values. The empirical evidence suggests that the introduction of derivatives does not destabilize the underlying market—either there is no effect or there is a decline in volatility—and that the introduction of derivatives tends to improve the liquidity and informativeness of markets.

1

Introduction

Writing in 1688, Joseph de la Vega describes various strategies used by a syndicate of bear traders to manipulate prices in the market for Dutch East India Shares at the Amsterdam Exchange. Some of these tricks involved trading options. For example, de la Vega reports that one strategy employed by the bears was to... ... enter as many put contracts as possible, until the receivers of premiums [assumed to be bulls] do not dare buy more stock [on their own initiative]. [Their hands will be largely tied] because they are already obliged to take the stock [covered by the put premiums, if requested to do so]. Therefore the speculation for the decline has free course and is an almost sure success. Roger Lowenstein, writing in the Wall Street Journal, November



References: Empirical [1] Abhyankar, Abhay H., 1995, Return and Volatility Dynamics in the FT-SE 100 Stock Index and Stock Index Futures Markets, Journal of Futures Markets 15, 457-488 49 [18] Bhattacharya, Mihir, 1987, Price Changes of Related Securities: The Case of Call Options and Stocks, Journal of Financial and Quantitative Analysis 22, 1-15 52 [76] Ghosh, A., 1993, Cointegration and Error Correction Models: Intertemporal Causality between Index and Futures Prices, Journal of Futures Markets 13, 193-198 53 [97] Kabir, Rezaul, 1997, New Evidence on Price and Volatility Effects of Stock Option Introductions, Working paper, Tilburg University

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