Too Many Options? Theory and Evidence on Option Exchange Design

Abstract

In this paper I propose and test a model of option exchange design when investors choose among several exchange-traded options based on a trade-off between standardization costs and liquidity/transaction costs. The model employs a spatial economics approach to provide results for the existence of markets for particular option contracts on the exchange, a comparison of exchange design by a social planner and a profit-maximizing monopolist (corresponding to the idea that most derivatives exchanges centralize the design and creation of option contracts), and comparative statics which can potentially aid decision-makers in the design of option exchanges. In the empirical work, open interest is analyzed for CBOE options on the stocks in the S&P 100 index. In accordance with the model's predictions, open interest forms a previously undocumented seesaw pattern across strike prices, clustering around certain strike prices, and dropping off for the adjacent strike prices.

Keywords: Options, Exchange Design, Open Interest

JEL Classification: G13