The value of liquidity: evidence from the derivatives market

Abstract

This paper documents the systematic overpricing of warrants relative to options. Models are developed in order to explain the cross-sectional variation in the relative pricing of these securities. Results indicate that pricing differences are related to various proxies of liquidity including: days-to-maturity, relative trading volume and the mandated presence of market makers in the options market. The identity of warrant-issuers is also found to be significant in explaining relative pricing, possibly reflecting disparate levels of credit risk or it may be a manifestation of the different characteristics relating to the underlying shares upon which the warrants are issued. The paper also documents the impact that the change from floor-trading to electronic-trading had on the price formation process in the Australian Options Market.