Department of Economics, UCSD

In this paper, we examine the impact of market activity on the percentage bid-ask spreads of S&P 100 index options using transaction data. We propose a new market microstructure theory called a derivative hedge theory, in which option market percentage spreads will be inversely related to the option market maker's ability to hedge his positions in the underlying market, as measured by the liquidity of this underlying market. In a perfect hedge world, spreads arise from the illiquidity of the underlying market, rather than from inventory risk or informed trading in the option market itself.

We estimate three models to investigate various market microstructure theories. In the static model, option spreads are a function of moneyness, time to maturity, option prices, hedge ratios and volatility. The dynamic model includes time between trades or duration and average volume per transaction while the cross-market model adds cross option market activity and spreads in the underlying market.

We find option market volume is not a significant determinant of option market spreads, which challenges the validity of volume as a proxy for liquidity and supports my theory. Option market spreads are positively related to spreads in the underlying market, again supporting our theory. However, option market duration does affect option market spreads, with very slow and very fast option markets both leading to bigger spreads. Only the fast market result would be predicted by asymmetric information theory. Inventory models predict big spreads in slow markets. Neither would be observed if the underlying securities market provided a perfect hedge. We interpret these mixed results to mean that the option market maker is able to only imperfectly hedge his positions in the underlying securities market.

Our result of insignificant option volume casts doubt on the price discovery argument between stock and option markets (Easley, O'Hara, and Srinivas (1997)). Asymmetric information costs in either market are naturally passed to the other market by market maker's hedging and therefore it is unimportant where the informed traders trade.