Derivative Security Induced Price Manipulation

Michael Gallmeyer and Duane Seppi

No 2000-E41, GSIA Working Papers from Carnegie Mellon University, Tepper School of Business

Abstract: This paper investigates the potential contribution of cash market price manipulation to an option's value. When the underlying's transaction price follows an exogeneous fundamental process plus a price impact component influenced by trade, both sides of an option position may try to move the underlying cash price. Optimal cash trading strategies consist of a manipulation component and a liquidity provision for the other traders in the market. When the price impact is transitory, the optimal cash strategy may involve ``pre-liquidation'' of manipulative cash trades to reduce trading costs. We find that cash market manipulation can represent a significant portion of an option's value. The price impact of manipulation can be non-monotonic and the optimal cash trading strategy can be discontinuous in the number of longs and shorts.

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