Does the Introduction of One Derivative Affect Another Derivative? The Effect of Credit Default Swaps Trading on Equity Options

59 Pages Posted: 16 May 2018 Last revised: 19 May 2021

See all articles by Jie Cao

Jie Cao

The Hong Kong Polytechnic University - School of Accounting and Finance

Yong Jin

The Hong Kong Polytechnic University

Neil D. Pearson

University of Illinois at Urbana-Champaign - Department of Finance

Dragon Yongjun Tang

The University of Hong Kong - Faculty of Business and Economics

Date Written: May 19, 2021

Abstract

A significant event for equity options since the 1987 stock market crash is the rise of credit default swaps (CDS). We show that equity options of CDS-referenced firms are more expensive than those without CDS. Instrumental variable estimation and other analysis suggest that the CDS effect on option pricing is likely causal. Transactions data reveal that brokers and dealers’ demand is higher for options linked to CDS. The effect of CDS trading on option pricing is more pronounced when financial institutions have less capital or higher leverage. Our findings are consistent with theories that intermediation capacity constraints affect derivatives pricing.

Keywords: Credit default swap, delta-hedged option return, demand-based option pricing, financial intermediation capacity, intermediary-based asset pricing

JEL Classification: E44, G01, G12, G13, G2

Suggested Citation

Cao, Jie and Jin, Yong and Pearson, Neil D. and Tang, Dragon Yongjun, Does the Introduction of One Derivative Affect Another Derivative? The Effect of Credit Default Swaps Trading on Equity Options (May 19, 2021). Available at SSRN: https://ssrn.com/abstract=3158676 or http://dx.doi.org/10.2139/ssrn.3158676

Jie Cao

The Hong Kong Polytechnic University - School of Accounting and Finance ( email )

Hung Hom, Kowloon
Hong Kong

HOME PAGE: http://sites.google.com/site/jiejaycao

Yong Jin

The Hong Kong Polytechnic University ( email )

Hong Kong

Neil D. Pearson (Contact Author)

University of Illinois at Urbana-Champaign - Department of Finance ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
217-244-0490 (Phone)
217-244-9867 (Fax)

Dragon Yongjun Tang

The University of Hong Kong - Faculty of Business and Economics ( email )

KKL 1004
Pokfulam Road
Pokfulam
Hong Kong
(852)22194321 (Phone)

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