Dr. Tyler Brough of Utah State University
Automated Trader: What prompted your research in this area?
Tyler: It builds upon a paper by Chakravarty, Gulen and Mayhew2 which made use of a vector error correction model that was originally designed by Joel Hasbrouck to examine what happens when the same stock trades in different markets. This explored the sharing of information and how the price discovery of smaller markets essentially borrowed from the price discovery process in their larger peers.
However, one of the most intriguing things about Mayhew, Gulen and Chakravati's research is that it used Hasbrouck's econometric tool to explore the price discovery relationship between stocks and their listed options, rather than the same stocks listed on different cash markets. This was methodologically interesting because they obviously could not directly compare price of the underlying and its derivative. Instead they had to use the option price to estimate an implied underlying price, much as one might when calculating implied volatility. That was not a trivial task because it had to accommodate the multiple strikes and expiry dates of the associated options.
Their conclusions were that the option market was essentially leading the underlying market. However, their findings were contradicted by a paper that came out last year3 (albeit based upon a relatively small sample of 39 liquid NYSE stocks) that found that quotes in the options market lagged those in the underlying market.
Automated Trader: I suppose you could argue that the activity of informed traders in option markets would make it plausible for options to lead their associated stocks?
Tyler: Exactly. If you were an informed trader, which market would you prefer to trade in? Although liquidity may be lower in derivative markets, transaction costs are also lower and greater leverage is possible. If information leakage is a concern, an informed trader may also find it easier to mask their intentions in the options market. Finally, if there are short selling constraints in the underlying market, then the options market is the logical alternative venue.
Our view is that where markets are tightly coupled, the activity of informed traders or information flowing through the options market to the underlying market, might drive prior price discovery in the derivatives contract.
Automated Trader: What methodology did you use in your research to test this hypothesis?
Tyler: We used the Hou and Moskowitz methodology of price delay4. This can be thought of as a market model where one can lag the market component out a certain number of periods. Then when one regresses the returns of some security onto that, the significance of the lag coefficients tells you at what rate that security adjusts to market-wide information. So it is essentially a measure of the speed of price discovery.
We used this methodology in conjunction with an event study around option listings. We looked at underlying securities that were eligible for an option contract to list and then compared those that did and didn't list options by calculating their respective price delays (the time taken for market information to affect the price of a security).
Automated Trader: Given that the paper that contradicted Mayhew, Gulen and Chakravati's research was based upon a relatively small selection of stocks, what range of data did you use in your testing?
Tyler: We examined 2,523 stocks from the NYSE and NASDAQ from January 1997 to December 2007 that listed options during that period. We obtained monthly returns, volume, prices, shares outstanding, and market capitalisation data on the stocks from the Center of Research on Security Prices (CRSP) and data on the number of option contracts traded from Bloomberg.
Automated Trader: How did you analyse the price delay data?
Tyler: We used the CRSP data to calculate weekly returns for each stock from Wednesday to Wednesday. We then used the Hou and Moskowitz methodology mentioned earlier to calculate the price delays. We then began our analysis by examining statistics that described our sample both before and after options become available. However, we also controlled for other factors that Hou and Moskowitz found affected the level of price delay, including contemporaneous market capitalisation, book-to-market ratio, institutional ownership, return volatility and turnover.