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
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: Suggested Citation