The Impact of Option Introduction on Stock Return Variances: The Role of Bid-Ask Spreads, Return Autocorrelations, and Intrinsic Variances

The purpose of this paper is to examine changes in stock return variances following option introduction. The sample consists of National Market System stocks and employs both transaction returns and returns based on bid and ask quotes. Variances are decomposed into portions attributable to bid-ask spreads, return autocorrelations, and intrinsic variances. Spreads play a negligible role in explaining variance changes. A generally positive component to short-term autocorrelations falls following option introduction, increasing variances over short holding periods. Intrinsic variances fall prior to the October 1987 crash, but do not change after the crash with option introduction.     

Information Effects on the Bid-Ask Spread

An individual who chooses to serve as a market-maker is assumed to optimize his position by setting a bid-ask spread which maximizes the difference between expected revenues received from liquidity-motivated traders and expected losses to information-motivated traders. By characterizing the cost of supplying quotes, as writing a put and a call option to an information-motivated trader, it is shown that the bid-ask spread is a positive function of the price level and return variance, a negative function of measures of market activity, depth, and continuity, and negatively correlated with the degree of competition. Thus, the theory of information effects on the bid-ask spread proposed in this paper is consistent with the empirical literature.     

A note on the impact of options on stock return volatility

This paper measures the impact of option introductions on the return variance of underlying stocks. Past research generally finds a significant reduction in stock return variance following the listing of options through 1986. Using a more extensive sample, I compare changes in the return variance of optioned stocks to changes in the return variance of a control group. Since the average change in the control group is statistically indistinguishable from the average change in the optioned stocks, I conclude that option introductions do not significantly affect stock return variance.     

OPTIONS LISTING, MARKET LIQUIDITY AND STOCK BEHAVIOUR: SOME CANADIAN EVIDENCE

This study examines the price behaviour, trading volume and liquidity of stocks in the Canadian market at the time of options listing. Unlike some studies examining similar effects in the United States, the present one finds no evidence to indicate that either daily return volatility or trading volume is affected by the listing. Similarly, liquidity, as measured by the bid-ask spread, is unaffected. At the same time, cross-sectional tests indicate an inverse relationship between before-to-after trading volume and the before-to-after bid-ask spread.     

Stock price synchronicity and liquidity

We argue and provide evidence that stock price synchronicity affects stock liquidity. Under the relative synchronicity hypothesis, higher return co-movement (i.e., higher systematic volatility relative to total volatility) improves liquidity. Under the absolute synchronicity hypothesis, stocks with higher systematic volatility or beta are more liquid. Our results support both hypotheses. We find all three illiquidity measures (effective proportional bid-ask spread, price impact measure, and Amihud's illiquidity measure) are negatively related to stock return co-movement and systematic volatility. Our analysis also shows that larger industry-wide component in returns improves liquidity. We find that improvement in liquidity following additions to the S&P 500 Index is related to the stock's increase in return co-movement.     

Components of the Bid-Ask Spread and the Statistical Properties of Transaction Prices

The bid-ask spread can be decomposed into two parts: one part due to asymmetric information and the other part due to other factors such as monopoly power. The part due to asymmetric information attenuates statistical biases in mean return, variance, and serial covariance. Thus, using spread data to adjust for biases in return moments requires knowing not only the spread but the composition of the spread. Furthermore, any spread-estimation procedure using transaction prices must estimate two spread components. On the other hand, the appropriateness of some previously suggested statistical corrections is independent of the spread composition.     

Adverse Selection and the Required Return

An important feature of financial markets is that securitiesare traded repeatedly by asymmetrically informed investors.We study how current and future adverse selection affect therequired return. We find that the bid-ask spread generated byadverse selection is not a cost, on average, for agents whotrade, and hence the bid-ask spread does not directly influencethe required return. Adverse selection contributes to trading-decisiondistortions, however, implying allocation costs, which affectthe required return. We explicitly derive the effect of adverseselection on required returns, and show how our result differsfrom models that consider the bid-ask spread to be an exogenouscost.     

Intraday Return Volatility Process: Evidence from NASDAQ Stocks

This paper presents a comprehensive analysis of the distributional and time-series properties of intraday returns. The purpose is to determine whether a GARCH model that allows for time varying variance in a process can adequately represent intraday return volatility. Our primary data set consists of 5-minute returns, trading volumes, and bid-ask spreads during the period January 1, 1999 through March 31, 1999, for a subset of thirty stocks from the NASDAQ 100 Index. Our results indicate that the GARCH(1,1) model best describes the volatility of intraday returns. Current volatility can be explained by past volatility that tends to persist over time. These results are consistent with those of Akgiray (1989) who estimates volatility using the various ARCH and GARCH specifications and finds the GARCH(1,1) model performs the best. We add volume as an additional explanatory variable in the GARCH model to examine if volume can capture the GARCH effects. Consistent with results of Najand and Yung (1991) and Foster (1995) and contrary to those of Lamoureux and Lastrapes (1990), our results show that the persistence in volatility remains in intraday return series even after volume is included in the model as an explanatory variable. We then substitute bid-ask spread for volume in the conditional volatility equation to examine if the latter can capture the GARCH effects. The results show that the GARCH effects remain strongly significant for many of the securities after the introduction of bid-ask spread. Consistent with results of Antoniou, Homes and Priestley (1998), intraday returns also exhibit significant asymmetric responses of volatility to flow of information into the market.     

Analysis of REIT IPOs Using a Market Microstructure Approach: Anomalous Behavior or Asset Structure

In this research, we examine and present new evidence on the market activity following the initial public offering (IPO) of a real estate investment trust (REIT) using microstructure data. We analyze the bid-ask spread differences for REIT securities compared to common stocks and closed-end funds for all IPOs between 1985 and 1988. Our results show that REITs, as a whole sample, experience significantly greater bid-ask spreads immediately following the IPO compared to common stocks and funds. However, this outcome is driven by the equity REIT sample, with the mortgage REIT sample having significantly smaller bid-ask spreads. This is in contrast to the evidence documented by Nelling, Mahoney, Hildebrand, and Goldstein (1995). We attribute our result to the underlying asset structure (such as equity, hybrid, and mortgage portfolios) of the various REITs. Overall, however, we find that bid-ask spreads for REITs are similar to those of common stock when both asset structure and the traditional determinants of the spread (share price, trade volume, and returns variance) are considered.     

The Effect of Option Trading on the Structure of Equity Bid/Ask Spreads

This paper investigates empirically the direct effect of option trading on the structure of costs that comprise the underlying equity bid-ask spread. Our results show that the spread declines over a 30-day period following initiation of option trading, but the decline vanishes when price, volume, and volatility effects are considered. Changes in the composition of the spread reflect primarily a reduction in adverse information costs. Additionally, consistent with previous research, we find significant transaction-type clustering in our intraday data.     

Competitive inventory management in Treasury markets

We decompose US Treasury bid-ask spreads into inventory, adverse selection and order processing costs by using the fact that inventory trades have different effects on spreads than do proprietary trades. We exploit this asymmetry and develop a technique to identify the three components of the spread in order to test three hypotheses: dealers make larger changes to inventory (1) following macroeconomic announcements (2) at the start and toward the end of the New York trading hours, and (3) when transaction sizes are relatively large. We test these predictions using GovPX data for on-the-run 2-year and 10-year Treasury Notes. All three predictions are supported. We also assess how primary dealers react to the Federal Reserve’s open market operations (OMOs). Our findings reveal interesting intraday patterns in the inventory component for both securities.     

Liquidity of the CBOE Equity Options

We examine the CBOE option market depth and bid-ask spreads. Absence of price effects surrounding large option trades suggests excellent market depth. However, bid-ask spreads for the CBOE options and the NYSE stocks are nearly equal, even though an average option is equivalent to less than half a stock plus borrowing. We explain this tradeoff between market depth and bid-ask spreads on the CBOE and the NYSE by differences in market mechanisms. We also show that the adverse-selection component of the option spread, which measures the extent of information-related trading on the CBOE, is very small.     

An empirical examination of the impact of market microstructure changes on the determinants of option bid-ask spreads

This paper examines the determinants of bid-ask spreads in the Australian Options Market before and after it switched from a quote-driven floor-traded market to an order-driven screen-traded market. This study reports that both put and call option bid-ask spreads are positively related to the option's value, its remaining term-to-maturity, its absolute hedge ratio and the volatility of returns from the underlying asset and negatively related to the level of trading activity in that option series. The study also reports that spreads are generally less when market makers are obliged to maintain continuous quotes in the market. The paper also finds that following the change in trading regime, both call and put option spreads became more sensitive to the absolute value of the option's delta. This finding is consistent with previous theoretical and empirical work from equities markets that has suggested that a switch to an electronic trading regime results in an increase in the adverse selection component of the bid-ask spread. There is also some limited evidence that suggests that the switch to electronic trading resulted in call option spreads being less sensitive to the return volatility of the underlying asset but more sensitive to the option's price.     

The Changing Asymmetric Information Component of REIT Spreads: A Study of Anticipated Announcements

This study examines the risk-compensating behavior of REIT market makers. The bid-ask spread is hypothesized to compensate market makers for three costs: asymmetric information, order processing, and inventory. As the market makers perceived likelihood of transacting with a better-informed individual increases (decreases), the percentage of the spread that is attributed to asymmetric information will increase (decrease). This study examines the asymmetric information component of the bid-ask spread immediately prior to and following REIT dividend announcements and REIT funds from operations announcements during 1995 and 1996. The asymmetric information component increases the day before and then declines subsequent to dividend announcements of small and equity REITs. Asymmetric information costs increase following funds from operations announcements.     

The impact of option introduction on the conditional return distribution of underlying securities

This paper combines several interesting econometric techniques to examine changes in the conditional return distribution of security returns following option introduction. An EGARCH model is used to characterize the return generating process. An intervention analysis is performed to determine whether the parameters of the EGARCH model shift following initial options listing. This paper finds that the conditional distribution of security returns is unaffected by option introduction. Estimation of a transfer function-noise model also shows that option introduction has no effect on conditional volatility.     

Liquidity skewness in the London Stock Exchange

We study liquidity on the London Stock Exchange. We find that the average bid-ask spread declines, but that the skewness of the spread increases. These results are robust to firm size, trading volume and price level. Our findings hold when the bid-ask spread is estimated utilising high frequency data. We find that the bid-ask spread prior to earnings announcements dates is significantly higher than that of post earnings announcements, suggesting that asymmetric information has driven the increase in liquidity skewness. We also find that the effect of earnings announcements is more pronounced in the 2007 global financial crisis, consistent with the notion that extreme market downturns amplify asymmetric information. Our overall evidence also implies that increased competition and transparent trading environments limit market makers' abilities to cross-subsidize bid-ask spreads between periods of high and low levels of asymmetric information.     

Estimation of the effective bid-ask spread on high frequency Danish bond data

In this paper the effective bid-ask spread is estimated using 12 high frequency Danish bond samples. A clear-cut MA(1)-model for the mean of the return series, and a GARCH(1,1)-model for the variance, are found. Basically, Roll's model is used, but three different methods of calculating the first-order autocovariance are suggested. Each of these in turn produces three possible ways of estimating the effective bid-ask spread. First, Roll's original autocovariance estimate is used. Second, the autocovariance is calculating using the parameters of an estimated MA(1) model. Third, the autocovariance is obtained from the parameters of a joint MA(1)-GARCH(1,1) model. By means of bootstrapping the standard error of the bid-ask spread estimates are found. It is shown that the gain in efficiency, measured by the relative difference in the standard error of the estimates, is 29% when going from method one to method two, but only 1% when going from method two to method three. These results indicate that the extra gain in efficiency obtained by taking account of the MA(1) structure of the data is noteworthy, but the gain when incorporating the GARCH-effects is negligible.     

New evidence on the price and liquidity effects of the FTSE 100 index revisions

We study the price and liquidity effects following the FTSE 100 index revisions. We employ the standard GARCH(1,1) model to allow the residual variance of the single index model (SIM) to vary systematically over time and use a Kalman filter approach to model SIM coefficients as a random walk process. We show that the observed price effect depends on the abnormal return estimation methods. Specifically, the OLS-based abnormal returns indicate that the price effect associated with the index revision is temporary, whereas both SIM with random coefficients and GARCH(1,1) model suggest that both additions and deletions experience permanent price change. Added (removed) stocks exhibit permanent (temporary) change in trading volume and bid-ask spread. The analysis of the spread components suggests that the permanent change associated with additions is a result of non-information-related liquidity. We interpret the permanent price effect of additions and deletions combined with the permanent (temporary) shift in liquidity of added (removed) stocks as evidence in favour of the imperfect substitution hypothesis with some non-information-related liquidity effects in the case of additions.     

EVIDENCE ON THE BEHAVIOR OF BID AND ASK PRICES AT THE TURN OF THE YEAR: IMPLICATIONS FOR THE SURVIVAL OF STOCK RETURN SEASONALITY

We analyze changes at the turn of the year in the relative and standardized bid-ask spreads of New York Stock Exchange stocks before and after the introduction of personal income taxes in 1917. Previous research indicates the return seasonal arose in 1917. Here, we investigate when spread seasonals arose and whether spread changes are cross-sectionally correlated with the return seasonal. The results indicate that the year-end selling pressure, which began in 1917, is apparent as downward shifts in the stocks' bid and ask prices rather than as widening spreads. Additional evidence suggests the January return seasonal originated as compensation to specialists, as well as to competing traders, for incurring the costs of providing liquidity during the tax-induced seasonal trading pattern.