Liquidity as Information Signal: Evidence from Currency Options Market

Abstract

We examine the systematic component of liquidity as source of information signal which lead to price changes in the currency options market. Using daily data from spot and currency options markets for the USD-INR currency, the paper investigates the interrelationship of currency options liquidity with spot exchange rate returns and volatility, and speculative tendency in the options market. We use modified Amihud (2002) in a time-series framework as a measure of market-level illiquidity in the currency options market. Cointegration and vector error correction model estimation approaches are employed to examine the causal relationship among illiquidity, volatility, returns and speculation in currency options market. We find that the change in spot exchange rate is statistically significantly related to options market liquidity. The illiquidity is negatively associated with asset returns implying that less liquid assets are valued lower due to transaction and other costs; this illiquidity premium is over and above the risk premium. Our results from VECM estimations suggest that there exists bidirectional causality between illiquidity and speculative activities, and that higher volatility is reinforced by illiquidity in currency options market. Finally, we provide empirical evidence in favor of liquidity acting as an information signal for speculators and driving further speculation in the options market for the USD-INR currency pair.

Keywords: Currency options, Liquidity, Volatility, Exchange Rate, Speculation, VECM

JEL Classification: G12, G14, F31