Alternative Market Structures for Derivatives

Söhnke Bartram and Frank R. Fehle
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Frank R. Fehle: University of South Carolina

Finance from University Library of Munich, Germany

Abstract: In this paper, we compare option contracts from a traditional derivatives exchange to bank-issued options, also referred to as covered warrants, whose markets have grown rapidly around the world in recent years. While bank-issued option markets and traditional derivatives exchanges exhibit significant structural differences such as the absence of a central counterparty for bank-issued options, they frequently exist side-by-side, and the empirical evidence shows that there is significant overlap in their product offerings. We examine trading costs and liquidity in both markets and find that bank-issued options have smaller quoted percentage bid-ask spreads than traditional option contracts by an average of 4.3%. The bid-ask spread difference manifests itself in a highly regular fashion in that ask (bid) prices for bank-issued options are consistently higher than comparable ask (bid) prices for traditional option contracts. The difference of the bid prices is larger than the difference of the ask prices resulting in smaller bid-ask spreads for bank-issued options. The empirical analysis also indicates that bid-ask spreads in either market are lowered by competition from the other market. We present a potential explanation for the co-existence of the two market structures which suggests that the bank-issued option market caters more towards retail investors with predominantly speculative motives while traditional derivatives exchanges may cater more towards institutional investors with predominantly hedging motives.

Keywords: Options; Market Design; Microstructure; Bid-Ask Spreads (search for similar items in EconPapers)
JEL-codes: G10 G13 (search for similar items in EconPapers)
Pages: 47 pages
Date: 2003-11-13, Revised 2003-12-12
New Economics Papers: this item is included in nep-fmk and nep-rmg
Note: Type of Document - PDF; prepared on IBM PC; pages: 47
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0311007

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