EUROPEAN. ThePriceandRiskEfects ofoptionintroductionsonthenordicmarkets. EconomicPapers434 December2010. StafanLindén EUROPEANCOMMISSION

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1 EUROPEAN ECONOMY EconomcPapers434 December heprceandrskefects ofoptonintroductonsonthenordcmarkets StafanLndén EUROPEANCOMMISSION

2 Economc Papers are wrtten by the Staff of the Drectorate-General for Economc and Fnancal Affars, or by experts workng n assocaton wth them. he Papers are ntended to ncrease awareness of the techncal work beng done by staff and to seek comments and suggestons for further analyss. he vews expressed are the author s alone and do not necessarly correspond to those of the European Commsson. Comments and enqures should be addressed to: European Commsson Drectorate-General for Economc and Fnancal Affars Publcatons B-49 Brussels Belgum E-mal: Ecfn-Info@ec.europa.eu hs paper exsts n Englsh only and can be downloaded from the webste ec.europa.eu/economy_fnance/publcatons A great deal of addtonal nformaton s avalable on the Internet. It can be accessed through the Europa server (ec.europa.eu) KC-AI--434-EN-N ISSN ISBN do.765/46537 European Unon, Reproducton s authorsed provded the source s acknowledged.

3 he Prce and Rsk Effects of Opton Introductons on the Nordc Markets Staffan Lndén Stockholm School of Economcs Sprng Abstract hs paper examnes the effects of opton ntroductons on the prce and rsk of the underlyng assets. he data, coverng 58 ntroductons durng the perod , have been collected from the Nordc markets (Denmark, Fnland, Norway, and Sweden). A persstent ncrease of stock returns s found rght after the announcement date, rather than at the ntroducton date, as n US data. he volatlty s found to decrease contnuously over the tenmonth perod followng the ntroducton of stock optons. Introducton. Background Wth the openng of the Chcago Board Optons Exchange (CBOE) n 973 a new era of dervatve tradng started. CBOE revolutonzed the opton tradng by Frst and foremost I wsh to thank my advsors, Clas Bergström, Bertl Näslund, and Jonas Nemeyer, for gudance and encouragement. I am very much ndebted to Ken Bechmann for nvaluable suggestons and support. I also wsh to thank Bent-Jesper Chrstensen, Carsten Sörensen, and semnar partcpants at Aarhus Unversty, Copenhagen Busness School, and Stockholm School of Economcs; and partcpants at the 7th annual meetng of the European Fnance Assocaton. I also very much apprecate the help from Charlotte Karlsson at OM as well as Are Grongstad and Ger Aase at Oslo Stock Exchange for provdng the announcement and ntroducton dates of the optons traded at OM and OSE. Moreover, I want to thank Petr Sahlström at the Swedsh School of Economcs and Busness Admnstraton for provdng the ntroducton dates of the optons traded at Helsnk Stock Exchange (HSE). he vews expressed here represent only those of the author and not necessarly the European Commsson.

4 creatng standardzed, lsted stock optons. In the same year Black and Scholes (973) publshed ther work on opton prcng. hey assumed that optons are redundant assets and could thereby derve a prcng rule for dervatve securtes. hs was done by applyng a no-arbtrage argument and by constructng a dynamc hedge portfolo. Snce then academcs have questoned the assumpton of redundancy. Researchers recognze that fnancal markets are not complete. herefore, ntroducng dervatve securtes could ncrease the opportunty set of nvestors, whch n turn could make markets more effcent, lead to welfare effects, and make the dervatves market nteract wth the underlyng securtes market (see e.g. Ross (976), Hakansson (98), and Detemple and Selden (99)). hs study emprcally nvestgates the effects of opton ntroducton on the prces and rsk of the underlyng securtes. he data used come from the stock markets n Denmark, Fnland, Norway, and Sweden as well as from the opton market n Sweden. he study s motvated fourfold: (). One reason s to check the results and mplcatons of theores regardng opton ntroducton presented n the academc lterature. (). So far most studes concernng the mpact of opton lstng on the underlyng stock has been based on data from the Unted States. o confrm the results from these studes evdence from other data sets are needed. (). Recent studes based on US data have found tme-varyng prce and rsk effects. hese, from most other fndngs dvergent, results wll be compared wth those based on data from the Nordc markets. (v). Polcy questons arse, because there s a fear that dervatve tradng adds to the nstablty of the underlyng assets market. Not rarely such tradng gets the blame for ncreased uncertanty. he proposed solutons to the presumed problem nclude ntroducng frctons nto the market, such as turnover taxes on short-term postons, to reduce the speed of transactons. Although no explct conclusons can be drawn, t s worthwhle checkng f the allegaton of addng nstablty has any emprcal support. here are several arguments suggestng that there exst effects on the underlyng stock returns related to the lstng of optons. he structure, magntude or even the drectons of these effects are debatable, but they are potentally of great nterest, not only to academcs but also to practtoners and market regulators. However, a better understandng of the effects nvolved can only be determned emprcally. he dsposton of ths paper s as follows. he fnal part of the ntroducton provdes some theoretcal arguments leadng to the hypothess tested n the paper, and also gves a revew of the emprcal lterature. Chapter two dscusses the methodology. In the next chapter the data s descrbed. In chapter four the

5 results are presented, and n the fnal chapter the conclusons are summarzed. Appendx A and B put forward dervatons of parts of the methodology. In Appendx C all the shares of the companes used n ths study are lsted, together wth ther announcement and lstng dates.. heory and ested Hypothess he am of ths study s to contrbute to a better understandng of the effects of opton ntroducton by examnng evdence from the Nordc stock markets. here are several varables to be examned and there are several mechansms by whch the varables may be effected. More exhaustve revews, both regardng the theoretcal and emprcal lterature, can be found n the surveys of Damodaran and Subrahmanyam (99) and Gjerde and Sættem (994)... Prce Effects Dervatve securtes are effcent and flexble nstruments for controllng fnancal rsks. hese nstruments enable dfferent rsk postons and opnons about rsks to be expressed through tradng, and thereby contrbute to the reallocaton of the rsks among dfferent market partcpants. Among other thngs, the access to a developed opton market allows nvestors to unload ther rsks wthout havng to change ther postons n the underlyng stock. hs mples reduced transacton costs and makes t possble to manage better the nvestors rsk exposure n the underlyng market, whch should be benefcal both prvately and to the socety. In a complete market all assets are perfect substtutes, and contngent cash flow clams can be duplcated by combnng already exstng assets (see Black and Scholes (973)). In a complete market, optons are therefore redundant assets. An mportant economc theorem states that a complete market s always pareto-effcent, whle an ncomplete market may be pareto-neffcent (see Cox and Rubnsten (985, p 435). Practcal crcumstances prevent the constructon of such a complete market. Among other thngs, smple contracts may be dffcult to wrte and carry out, e.g. contracts on future labor ncome. Further, transacton costs and regulatons could make t dffcult to construct new dervatve securtes for all possble outcomes. Optons could therefore n practce contrbute to makng the captal markets more complete. o the degree that nvestors are better off by ther ncreased opportunty set when optons are ntroduced, t can be clamed that the addtonal tradng possbltes reduce the nvestors cost of captal and ncrease the prce of the underlyng stock. A negatve external effect of tradng optons could be that ths tradng dverts captal from the equty market to the dervatve market. hs could lead to a hgher lqudty premum, and therefore a hgher requred return and more he last survey of the two s wrtten n Norwegan. 3

6 expensve equty. Cox and Rubnsten (985) recognze a problem connected wth ths lne of argument, whch s n conflct wth a fundamental economc prncple. Call and put optons are contracts between ndvduals or fnancal ntermedares, and are not ssued by non-fnancal frms. At a natonal level, aggregated real asset value corresponds to the sum of aggregated equty, convertble nstruments, and debt. Lke any form of debt between ndvduals or fnancal ntermedares, optons are not ncluded n ths balance. A holder of an opton contract has clams correspondng to the other party s oblgatons. A buyer of a call opton s a potental buyer of the stock, but has not yet bought t. Smlarly, a seller of a call opton s a potental seller of the underlyng stock. herefore t s not correct to say that buyng an opton represents a reducton n the total net demand of the stock. A more nuanced argument would be that the avalablty of an opton market leads to a new equlbrum, whereby the total nvestment level could be ether hgher or lower. Few papers have theoretcally dealt wth the mplcatons from non-redundant opton markets for the underlyng prce. Detemple and Selden (987) provdes one lne of argument. hey construct a general equlbrum model of an economy consstng of a rsky asset and an opton, where the asset market s assumed to be ncomplete. he economy s populated by two types of nvestors, wth homogenous utlty functons, but wth dfferent belefs about the rsk connected wth stock prces. hey assume that there are two classes of nvestors who dsagree on the probablty of a fall of the stock prce,.e. there s a hgh-rsk group and a low-rsk group of nvestors. he opton ncreases the number of attanable returns. In ths ncomplete market the dervatve and the underlyng assets wll nteract,.e. ther valuaton becomes a smultaneous prcng problem. Indvduals wth hgh-rsk assessments have preferences for payoffs for hgh values of the stock, and therefore want to buy and hold call optons to hedge the downsde potental. For the hgh-rsk nvestors the opton serves as a substtute: they buy the call opton whle sellng some of ther shares n the endowed stock. he low-rsk nvestors do the opposte; they demand the stock and supply the call opton, and thus treat the dervatve securty as a complement to the stock. he net effect s that the demand for the stock ncreases. he stock s regarded to be more valuable when optons are ntroduced, and the prce ncreases. Further, the return volatlty of the stock decreases. he prce effect occurs ntally at the tme of the ntroducton of the call contract, but could be antcpated. hs could gve rse to an arbtrage opportunty. By buyng the stock before the actual ntroducton of the opton one could secure an addtonal proft. herefore, t s lkely that a prce effect should occur at the announcement date. he model has nothng to say about any welfare effects that could arse when an opton s ntroduced. But through an enhanced opportunty set, and gven the nvestors dfferent rsk assessments, consumpton can be more easly smoothed, 4

7 whch should be benefcal to the economy as a whole. he postve prce effect can be expected to be permanent, as the requred yeld on nvestments can be reduced. Conrad (989) suggests that another explanaton for a prce effect s the market makers hgher demand for stocks for hedgng purposes when new stock optons are ntroduced. In the case market makers antcpate wrtng calls, they mght demand the underlyng stock for nventory and hedgng purposes. hs should lead to a temporary prce ncrease, lkely to occur at the ntroducton day or a few days before the actual lstng of new dervatves. Vce versa, f the market makers antcpate wrtng puts, they may short the stock for the same reasons. hs should lead to a temporary prce pressure n the stock at the ntroducton date, or a few days before. Other examples can also be constructed, gvng rse to both prce ncreases and prce decreases. In an effcent market, prce changes can be expected to occur at the announcement date and not at the date of the opton ntroducton. If regulatory or nsttutonal constrants exst, t s possble to have a prce effect on the ntroducton date. In Haddad and Voorhes (99) t s argued that the most nterestng tme to analyze s the ntroducton date. Most opton-traders want to ssue covered optons, but ths strategy s not possble to mplement before the optons are actually traded... Rsk Effects Concernng the rsk effects of opton ntroductons, Grossman (988) states that tradng n standardzed dervatve contracts reveals nformaton about the demand for fnancal nsurance to the counterpart, who supples ths nsurance. He argues that the prce varance n the underlyng securty wll declne when trade n standardzed contracts s ntroduced, as opposed to the case when ths demand for fnancal nsurance s generated through dynamc tradng strateges,.e. re-balancng the portfolo between rsky assets and rsk-free lendng/borrowng. A purpose of hs study s to show how market frctons and ncomplete nformaton regardng the fracton of portfolo managers that mplement a dynamc hedgng strategy can leave lqudty provders unprepared to meet the ncreased supply nduced by the portfolo hedgers. hs causes the stock prce to be more volatle than t would have been f put optons had been traded. It s crucal that lqudty provders know the fracton of portfolo managers who decde to use dynamc hedgng strateges to be able to make a correct captal allocaton decson. In the absence of perfect nformaton about the fracton of portfolo nsurers, the lqudty provders wll choose to provde an amount of captal that s optmal for some average level of volatlty. hs leads to stuatons n whch the allocated captal s less than demanded n tmes of hgh volatlty, and s n excess n tmes of low volatlty. herefore, the stablzng 5

8 role of the lqudty provders wll be undermned by mperfect nformaton about the fracton of nvestors mplementng dynamc hedgng strateges. In ths stuaton a tradable put opton may have an mportant role to fll. Suppose there exsts a put opton, and that the portfolo nsurers mplement ther strateges va the dervatve contract. he prce of the put wll then reveal the fracton of nvestors commtted to dynamc hedgng strateges. In the presence of real traded dervatve contracts, the lqudty provders are nformed about the fracton of portfolo nsurers and thus can allocate ther captal n an optmal and market-stablzng way. herefore, t s ratonal to assume that the ntroducton of optons s lkely to reduce the total rsk. Focusng on two aspects of speculatve behavor, rsk-sharng and nformaton transmsson, Sten (987) analyzes the rsk effect connected wth the ntroducton of dervatves. In hs model the openng of a dervatve market produces new nvestment choces, and enables more and new agents to partcpate n the economy, whch mproves the rsk-sharng. he new agents are also dfferently nformed, whch can alter the nformatonal content of prces. Hs model llustrates that the openng of a dervatve market can be destablzng. wo mechansms wll determne the effects on prce volatlty and welfare. Frst, the openng of a dervatve market wll ntroduce more agents nto the economy, and make t possble to transfer the rsk of holdng nventores to the new pool of nvestors. When nventores are more easly carred forward from one perod to another, prces become more stable, whch leads to a smoother allocaton of consumpton. It s assumed that consumers have concave utlty functons. hence t follows that consumpton smoothng over tme s welfaremprovng. he second mechansm affectng the prces has to do wth the nference, whch can be drawn from the observed asset prce. If the dervatve market s n place, and the new traders have mperfect nformaton, ther speculatve tradng can reduce the nformatonal content of the asset s prce. hs muddlng of the traders nformaton has two effects. It rases ther condtonal varance of the future prce. Snce traders are rsk averse, they wll be more reluctant to hold an nventory, whch prevents consumpton smoothng. hs gves a destablzng effect. raders also make mstakes n ther storage decsons, because they have to statstcally predct the future prce. Agan, ths s destablzng. hese two effects are of course reduced by the rsk-sharng beneft provded by new traders. Stll, the net effect may be destablzng and welfare-reducng. hus the ntroducton of dervatve nstruments may also have a destablzng effect on the underlyng market, whch tends to ncrease volatlty and thereby the total rsk. Opton tradng could also open up opportuntes for a manpulaton of prces, and ths could lead to destablzaton. Examples of such a manpulaton are 6

9 strateges called poolng and cappng. When mplementng a poolng strategy, a holder of a call opton uses the fact that optons are hghly leveraged nstruments,.e. the value of an opton changes relatvely more than that of the underlyng stock. hus, by tryng to rase the stock prce, t s possble to gan an addtonal return on a long poston n a call opton wrtten on that partcular stock. hs strategy can be mplemented at any tme of an opton s lfe as soon as t s ntroduced. Cappng s a strategy where an ssuer of a call opton tres to push down the prce of the underlyng stock durng the tme of maturty. Sellng off stocks at ths partcular perod of tme can lead to a lower prce, whch reduces the value of the optons, and n the extreme case makes them worthless. he opposte tactcs, called peggng, can be used to avod such a reducton of the underlyng stock prce. Both "cappng" and "peggng" can contrbute to non-normal fluctuatons n the stock prce around the maturty of the opton. Another manpulaton opportunty s connected wth the front runnng of block holders, whch nvolves takng advantage of nformaton about a comng block trade by earnng a proft through buyng or sellng optons on the underlyng stock. hs type of acton s closer to nsder tradng, and s easer to regulate and supervse than the type of manpulatons mentoned above. Accordng to Damodaran and Subrahmanyam (99), arguments about the destablzng effect of opton tradng can be found n the popular press. In general, these arguments are not presented wthn the framework of a model, but are based on two factors, accordng to Damodaran and Subrahmanyam. Frst, n a market wth frctons n the tradng process, the actons of unnformed speculators can generate prce bubbles,.e. prces are determned by other factors than fundamental values. Second, actons lke programmed tradng by some market partcpants, such as ndex arbtrageurs and supplers of portfolo nsurance, tend to ncrease the speed of response to changes n market stuatons, whch can accelerate market declnes or ncreases, and thus add to volatlty..3 Revew of Emprcal Lterature he emprcal fndngs concernng the effects of opton ntroductons on the underlyng stock prces can be dvded nto at least four areas, namely () the prce level, () the volatlty, () the nformaton and prce adjustment process, and (v) the mcrostructure effects (.e. spreads and volume). hs study deals manly wth the frst two ssues. he followng revew of the emprcal lterature should by no means be seen as a complete revew. It s summarzed n able below. Further, snce ths study does not deal wth ssues concernng varatons here are some master theses from Stockholm Scool of Economcs (usng Swedsh data) that are dealng wth the ssues dscussed n ths study. hese papers wll not be taken nto consderaton n the revew that follows. 7

10 n the underlyng stock around the tme of maturty of the optons, such lterature wll be omtted n ths revew..3. Prce Effects Startng wth the prce effect, emprcal fndngs employng data from US markets suggest that opton ntroducton causes a permanent prce ncrease n the underlyng stock, begnnng a few days before the ntroducton. Usng a sample of 3 opton ntroductons between 973 and 986, Detemple and Joron (99) report postve abnormal returns averagng.6% on the lstng day, and.9% n the two weeks around the lstng date. hey also show that the effects are stronger n the earler part of ther samplng perod than n the later years. he prce effect also seems to be more assocated wth the tme of ntroducton, rather than the tme of announcement. Conrad (989) dstngushes between the announcement of a new lstng and the actual lstng. he sample used conssts of 96 opton ntroductons made between 974 and 98 at 3 dfferent dates. She fnds a postve abnormal return of.5% durng the perod from 3 days before to day after the opton lstng. She could fnd no prce effect around the announcement date. 3 he absence of an announcement effect s somewhat puzzlng snce nvestors should progressvely realze that the prces of newly optoned stocks usually ncrease. Hence, an announcement effect should appear. In a more recent study the prce effect s reconsdered. Sorescu () shows that the effect of opton ntroductons on the underlyng stocks s best descrbed by a two-regme swtchng means model. He fnds a postve return effect of.37 percent over an -day wndow around the lstng date of the optons ntroduced from 973 to 98. In the perod after 98 he fnds a negatve effect of -.5 percent. he sample conssts of 94 lstngs made on 877 separate dates. An attempt was made to explan the causes of the swtch n the prce effect by observable characterstcs of the optoned frms, nstead of by the underlyng economcs of opton ntroducton. wo such varables were age and sze, whch showed to be negatvely related to the tme of ntroducton. In the sample of the optoned stocks after 98, the frms are relatvely smaller and younger. For ths group of stocks, the costs of establshng short postons may be hgh before the opton lstng, such that nvestors wth negatve nformaton who do not own the stock are unable to borrow t. hese short sale restrctons are effectvely removed when optons are lsted. hus, negatve nformaton can be ncorporated n prces and lead to a negatve prce effect. Other characterstcs, also used, were the type of contracts lsted, and the tradng place of the optons and ther underlyng stock. 3 Other students of the return effect of opton ntroductons nclude Branch and Fnnerty (98), Rao and Ma (987), and Haddad and Voorhes (99). 8

11 he results show that the swtch around 98, from postve to negatve abnormal returns, s not related to the type or tradng place of the opton contract, nor to the age, sze or tradng place of the underlyng stock. he cross-sectonal characterstcs n the underlyng frms merely serve as proxes for the regme swtch. Recognzng that opton lstng s an endogenous decson made by exchanges, Mayhew and Mhov (999) nvestgate the factors affectng the exchanges lstng decsons. hey fnd that frm sze, volume, and volatlty are postvely related to the probablty of lstng. Usng these results, they construct matched samples of stocks that were elgble, but not selected, for opton lstng, and re-examne some of the opton lstng effects usng a control sample methodology, n order to correct for an eventual selecton bas problem. hey use a sample consstng of 953 stocks wth optons ntroduced between 973 and 996. he results show that there s a postve prce effect pror to 98 and a negatve one after 98. But n the years after 98 the control samples also show negatve excess returns. hus, the negatve return effect n the later perod s less pronounced than that reported by Sorescu, and n some cases t even dsappears. So far, most studes concernng the mpact of opton lstng on the underlyng stock have been based on data from the Unted States. here s, however, some evdence regardng the effects of opton ntroductons based on data sets outsde the US. Watt, Yadav, and Draper (99) used 39 opton lstngs (over 34 ndependent dates) made n the UK over the perod 978 to 989, and report a temporary prce ncrease of.3% mmedately pror to the lstng. Stuck and Wasserfallen (994) nvestgate the effect on stocks traded n Swtzerland. her sample conssts of opton ntroductons made at one sngle date n 988. hey fnd that the ntroducton of traded optons leads to a permanent and sgnfcant ncrease n the prces of %. Gjerde and Sættem (995) have a sample of 7 opton ntroductons, lsted at 4 ndvdual dates n Norway. hey report a temporary prce ncrease, gvng a postve excess return of % on the ntroducton day. Fnally, fndngs from the Netherlands, as reported by Kabr (998), ndcate a declne n the stock prces. he magntude of the declne was.3% over the days before the lstng and.46% on the day after the lstng. he sample used conssts of 53 opton lstngs made at 7 ndvdual dates durng the perod 978 to 993. here s one study based on stocks traded n Sweden by Alkebäck and Hageln (998). Manly they study the mpact of warrant ntroducton on the underlyng stocks, and for comparson they also study the effects of opton ntroductons made n Sweden. Alkebäck and Hageln report that the return s unchanged at the ntroducton of the optons. he dfferences between ths study and thers are that n ths study the sample of opton ntroductons nclude all 9

12 Nordc markets, and that the queston of an announcement effect s addressed. Further, the rsk analyss s extended to nclude both the effects on the systematc rsk and those on the unsystematc rsk. All the studes mentoned above, usng data from European markets, have the weakness of not consderng what happens at the announcement date. Another shortfall s that the studes usng data from Norway and Swtzerland contan very few ndependent observatons..3. Rsk Effects o date, most studes on the aspect of the mpact of opton markets are concerned wth the effects on volatlty. he consensus among studes usng samples up to the md-eghtes s strong regardng the effects, and the fndngs show that volatlty s reduced as a consequence of the ntroducton of optons. Applyng varance measures of excess returns, Conrad (989) fnds that the average varance, measured over the days precedng the opton ntroducton compared to the value measured over the followng days, shows a declne from.9% to.79%. At the ndvdual frm level, 86 of the 96 frms ntroduced durng the perod between 974 and 98 showed a reducton n varance. Sknner (989) proves a declne n varance of 7%-5% after the lstng of optons dependng on the tme nterval used. he sample conssts of raw returns from 34 stocks wth optons ntroduced durng the perod When the actual returns are adjusted day by day wth due allowance for the overall market returns, the declne s n the order of %. In a sample consstng of 3 stocks wth optons ntroduced durng the years between 973 and 986, Deemple and Joron (99) fnd that the total rsk declnes on an average by 7%. Damodoran and Lm (99) document a sgnfcant declne n the return varance of %. her sample conssts of stocks wth optons ntroduced between 973 and 983. Nabar and Park (994) develop a market model approach to nvestgate the effects of optons on the underlyng assets, as opposed to the earler studes drected to tests of varance ratos. In a sample of 39 optoned stocks ntroduced at 53 dfferent dates, they fnd that the varance corrected for market rsk s reduced on the average by 4-8%. 4 Mayhew and Mhov (999) fnd dvergng results dependng on the tme perod studed. Between 973 and 98 they fnd decreasng volatlty compared to the control samples of stocks, but n the perod followng 98 they fnd mxed results. hey even report a sgnfcant ncrease n volatlty durng the perod 99 to 996. hey nterpret ths as f exchanges lsted optons n response to the stocks permanent characterstcs, but as these lstng canddates became fewer over tme, the exchanges gradually began lstng the optons n response to changes n market condtons. hus, ths reflects a 4 Other scholars have come to the same concluson regardng reduced rsk. Among these are Ma and Rao (988), and Bansal, Prut, and We (989).

13 change n the lstng crtera, the exchanges become forward-lookng, and lst optons n antcpaton of hgh volatlty. Another rsk examned s the non-dversfable rsk, measured by the beta of the underlyng stock. An early study by rennepohl and Dukes (979) uses a sample of weekly returns from 3 optoned stocks, whch were lsted between 97 and 976. he average weekly-return beta n ther sample declnes from. before the lstng to.87 after the lstng. Klemkosky and Maness (98) also come to a smlar concluson comparng monthly-return betas before and after the lstng of optons, but ther results are statstcally weaker. he sample conssts of monthly returns on 39 optoned stocks durng the perod More recent studes wth an mproved methodology and larger data sets have not been able to fnd any sgnfcant change n betas after the opton lstng. Examples of such studes are Whtesde, Dukes, and Dunne (983), Sknner (989), and Damodoran and Lm (99). he results reported by researchers usng data sets from non-us markets are as follows. Regardng the total rsk the results are mxed. Watt, Yadav, and Draper (99) report that the total rsk and the unsystematc rsk decreased n the UK. Stuck and Wasserfallen (994) nvestgate the effect on stocks traded n Swtzerland. hey fnd a reducton n the volatlty of the stock returns of 3%. Sahlström (998) usng a sample of 3 opton ntroductons made n Fnland, fnds that the total volatlty s reduced by 3%. he study based on stocks traded n Sweden by Alkebäck and Hageln (998) report that the varance declnes by 4%. Wth a sample of 37 opton ntroductons made over the perod 979 to 987 n Canada, Chamberlan, Cheung, and Kwan (993) fal to fnd any sgnfcant effects on rsk, volume, and bd-ask spreads. Gjerde and Sættem (995) fnd no evdence of a change n the total rsk of the stocks n Norway. Fnally, fndngs from the Netherlands, as reported by Kabr (998), ndcate no sgnfcant change n volatlty. he evdence on systematc rsk measured by beta s more conclusve. No effect s found n the studes from Canada, Norway, the Netherlands, Swtzerland, or the UK. he only excepton s the study based on Swedsh opton ntroductons, whch reports a declne n beta. In summary, the emprcal evdence on dfferent rsk measures ndcates that stock return varance declnes after opton lstng. hs s true for both total rsk and unsystematc rsk. Only a weak or, more recently, no statstcally sgnfcant change s found n the systematc rsk measured by the beta of the underlyng stock..3.3 Informaton and Prce Adjustment Process Effects Several studes have documented the speed at whch new nformaton s ncorporated n equty prces, both those wth and those wthout optons. At least three ssues n ths connecton are examned n the academc lterature. he frst one s concerned wth the effect opton lstng can have on the quantty and

14 qualty of the nformaton produced. he second deals wth the speed at whch the prces of optoned stocks respond to new nformaton relatve to nonoptoned stocks. A thrd ssue s to what extent opton prces lead or lag the prces of the underlyng stocks. Damodoran and Lm (99) study the ssue concernng the quantty and qualty of the nformaton produced. hey look at the number of analysts followng a stock and the frequency of Wall Street Journal artcles about the company before and after the opton lstng. hey conduct a test of whether the nformaton structure s affected by opton lstng, and fnd a sgnfcant ncrease n the number of analysts concerned wth stocks wth optons as well as a hgher frequency of Wall Street Journal artcles. he speed of prce adjustment to new nformaton has been studed by Jennngs and Stark (986), among others. In a sample of 8 stocks havng optons ntroduced durng 98 and 98, they fnd that the prce of the optoned stocks adjust more quckly to earnng reports than to the non-optoned stocks of a matched sample. Sknner (99), also studyng the effect of earnngs announcements on optoned stocks relatve to non-optoned stocks, reports smaller abnormal returns of unexpected news after the lstng of optons. Further, he concludes that the overall reacton to earnngs reports s smaller after the lstng of optons. he sample n Sknner s study conssts of 4 stocks havng optons ntroduced durng the perod 973 to 986, at 8 lstng dates. Usng the varance n dfferent return ntervals, Damodoran and Lm (99) estmate prce adjustment coeffcents. Usng a sample of frms coverng the perod of they fnd that prces adjust qucker to new nformaton after the lstng of optons. he last ssue, dealng wth whch market responds to new nformaton most quckly, the opton market or the stock market, has been addressed by Manaster and Rendleman (98), among others. hey use a sample of 7 stocks wth optons lsted between 973 and 976. hey fnd that the opton prces lead the stock prces by as much as 4 hours. In addton, they calculate the dfferences between mpled and actual stock prces. On the bass of these dfferences they construct portfolos, whch make excess returns. hs result, however, has been challenged n other studes. For example, Stephan and Whaley (99), usng ntraday prce changes n 364 stocks wth optons traded durng 986, fnd that opton prces lag stock prces by 5- mnutes. hey also document a modest feedback from the opton markets. In summary, there s evdence that opton lstngs enhance the nformaton set and ncrease the speed wth whch new nformaton s ncorporated n prces. However, the answer to the queston whether t s the opton market or the stock market that leads the nformaton revelaton remans open.

15 able Some Effects of Opton Lstng Presented below s a summary of studes mentoned n the text above regardng the effects of opton lstng on returns, total rsk, systematc rsk, bd-ask spreads, and volume. In these studes excess returns are defned as the dfference between the raw return and the market-adjusted return wth market model parameters estmated from a pror tme perod. he total rsk s usually measured by the return varance, sometmes adjusted to market varance. he systematc rsk s measured by the beta of a stock. he bd-ask spreads are estmated usng the Roll covarance method. he volume s measured by raw volume or marketadjusted volume. Weekly returns are used n earler studes and daly n the later ones. Study Country Sample Sze Sample Perod Excess return otal Rsk Systematc Rsk Bd-Ask Spreads Volume rennephol & Dukes (979) US Declne Klemkosky & Maness (98) US Declne Whtesde, Dukes, & Dunne (983) US None Conrad (989) US % -% None Sknner (989) US % None Increase Deemple & Joron (99) US % Damodoran & Lm (99) US % No change Watt, Yadav, & Draper (99) UK % -% None Chamberlan, Cheung, & Kwan (993) CAN None None None No change Nabar & Park (994) US % to -8% Stuck & Wasserfallen (994) SCH % -3% None Gjerde & Sættem (995) N % None None Declne Increase Alebäck & Hageln (998) S None -4% Declne Declne Increase Kabr (998) NL % None None Sahlstöm (998) FI % Declne Mayhew & Mhov (999) US < Increase Increase Sorescu () US Market Mcrostructure Effects heory suggests that optons tradng may have market mcrostructure effects. In the emprcal lterature t s hypotheszed that bd-ask spreads and tradng volume are affected. Damodoran and Lm (99) estmate the seral correlaton measure for the bd-ask spread proposed by Roll (984), usng a sample of frms wth optons ntroduced durng the perod hey reached the concluson that the bd-ask spreads declned after the lstng of optons. he declne s partally attrbuted to an ncrease n competton among market makers on the opton market, and s partally due to an ncreased nsttutonal tradng actvty n the stock. 5 Studes dealng wth the effects of opton lstng on tradng volume have come to dverged conclusons. Sknner (989) reports how the stock market tradng volume changes around the lstng tme of optons. he sample conssts 5 Others have also studed the effects on the bd-ask spread. Among them are Neal (987) and Fedena and Grammatkos (99), and they draw smlar conclusons as Damodoran and Lm (99). 3

16 of 97 frms wth optons ntroduced between 973 and 986. he result ndcates that the medan tradng volume n the stock ncreases after the lstng by 7%. 6 Lkewse, Damodoran and Lm (99) report an ncrease n the raw tradng volume of the same magntude, but when controllng for general market changes the effect s nsgnfcant. 7 In summary, t seems lke the bd-ask spread decreases after the lstng of optons, and there s no or lttle effect on the market-adjusted tradng volume of the underlyng stock..4 Hypothess Based on the arguments above, four explct hypotheses regardng a return effect are tested n ths study. Snce the return effect s a pror ndetermnate, both regardng the tme and the drecton of a shft, the tests are desgned to allow for ether an ncrease or a decrease n the returns. Further, an effect s allowed to take place at both the announcement date and the ntroducton date. If a shft n the return-generatng process s found, t s also tested f t s reversed at a later date followng ether the announcement or the ntroducton. he hypotheses are: (). Opton ntroductons do not lead to a change n the prce of the underlyng assets at the announcement date. (). In the case of a prce effect at the announcement, the effect s not reversed. (). Opton ntroductons do not lead to a change n the prce of the underlyng asset at the ntroducton date. (v). In the case of a prce effect at the ntroducton, the effect s not reversed. As regards a rsk effect, theory s not conclusve about n what drecton the rsk mght shft. hus, also n ths case, the tests must allow for ether an ncrease or a decrease n rsk. Moreover, the theoretcal analyses referred to above are not comprehensve enough to dsentangle whch rsks are affected and how,.e. the effect on the systematc and/or dosyncratc rsks. Accordng to the theores t s clear that the total rsk s affected, but t s hard to say what happens n a settng wth more than one asset and how ths affects the relaton wth other assets. hs rases the questons of whch rsks are affected, and how. hree explct hypotheses are tested n ths study concernng a rsk effect caused by the ntroducton of optons: 6 Jennngs and Stark (986) also fnd a postve volume effect of opton ntroducton. 7 Whtesde, Dukes, and Dunne (983) and Bansal, Prut, and We (989) draw smlar conclusons as Damodoran and Lm (99),.e. there s no change n volume when optons are ntroduced. 4

17 (v). Opton ntroductons do not change the total rsk of the nvestments n the underlyng assets, measured by the varance n returns. (v). Opton ntroductons do not change the dosyncratc rsk. (v). Opton ntroductons do not change the systematc rsk, measured by beta. Methodology. Return Effect o nvestgate the prce effect of an opton ntroducton, an event study s undertaken based on ntroducton of optons on the Nordc exchanges. he event s defned n two dstnct ways. he frst way s to use the announcement date of an opton ntroducton as t appears n a newsletter from Optons Mäklarna (OM) and Oslo Stock exchange (OSE), or n the newspaper Dagens Industr. he second way s to use the frst day of trade of the standardzed contract, as reported by the respectve exchange. hroughout the study, contnuously compounded returns are calculated n a standard fashon: ( pt + dt ) ln p r t = ln t () In the equaton above pt denotes the prce and dt denotes the dvdend at date t. he securtes on the Nordc exchanges are nfrequently traded n comparson wth stocks traded on the New York Stock Exchange (NYSE). hus, there wll be days wth no closng prces and therefore mssng values n the return seres. In such cases, a return s calculated for the perod of mssng prces. For example f closng prces are mssng for two days, a three-day return s calculated usng the thrd day's prce. In sample one and two, the event wndow s defned to be 6 days, that s 3 days pror to the event day and 3 days after the event day. Calculatng abnormal returns for a securty, the normal return over the event wndow s subtracted from the actual ex-post return. A modfed market model mplementng Fowler and Rorke (983) betas, whch adjusts for non-synchronous tradng, s used to model the normal returns. he parameters n the market model are estmated on data n a wndow of 5 days after the event wndow (see Fgure ). he preevent perod s used for alternatve choces of estmaton perods 8. 8 Other specfcatons of the estmaton perod are also tred, e.g. 5 days before and 5 days after the event wndow, and just 5 days before the event wndow. he choce does not affect the results. But, as wll be seen later, there s a rsk of a selecton bas n the data set, whch could have an nfluence on the estmaton of the parameters of the normal return models. 5

18 Fgure me Lne for the Event Study Pre-event perod Event w ndow E stm ato n perod m e n days When many optons n the sample are ntroduced on the same calendar date, cross-sectonal correlaton n excess returns could gve based results. herefore equally weghted portfolos are formed out of those stocks, whch have dentcal opton ntroductons and announcement dates. hese portfolos are treated as ndvdual securtes. An nference s drawn by calculatng z-scores from the standardzed excess returns of the securtes for each day n the event wndow. he methodology s more exhaustvely presented n Appendx A.. Rsk Effect he second part of ths analyss deals wth the effect of an opton ntroducton on the total rsk, the dosyncratc rsk and the systematc rsk of the underlyng securty. Usng a smlar event-study approach as n the analyss of the return effect, the total rsk effect s frst nvestgated... otal Rsk Monthly varances are estmated from daly returns for consecutve days. Snce there are perods of days wth no closng prces, there wll be days wthout returns. herefore some varances wll be estmated by usng fewer returns than. hs nfrequent tradng of securtes causes the returns to be autocorrelated, partcular at a one day lag (see Scholes and Wllams (973)). Because of ths autocorrelaton, varances are estmated as Nt v c c ( rtk rt ) + ( rtk rt )( rt, k rt σ ) () 9 Nt t = N t k = N t k = 9 It should be noted that the covarance term n equaton () does not enter by a factor two as t usually does. hs s due to a Newey-West correcton n order to make the varance-covarance matrx postve semdefnte n small samples (see Hamlton (994, p 8)). If the covarance matrx s not postve semdefnte, t s not asserted that all varances are non-negatve. 6

19 σ t Stock or market varance N Number of tradng days n a month r t tk v r t c r t Daly return n day k wthn month t Mean return n month t excludng mssng returns Mean return of the returns used when calculatng the one-perod lagged cross product A market model for monthly stock varance s used to descrbe the normal varance,.e. the ndvdual stock varance s expected to fluctuate around ts mean and the varance s adjusted for shfts n the overall market varance. hree dfferent market models for varances are consdered: σ = a + b σ + e t t t mt σ = a + b σ + e mt lnσ = a + b lnσ t t mt + e t (3) Nabar and Park (994) specfy these market models for volatlty ad hoc. hey use these models to answer smlar questons as asked n ths study, and they show that the methodology s statstcally more powerful than comparng varance ratos adjusted for market volatlty, as n Sknner (989). he advantage of ths specfcaton of normal varances s that t adjusts to a potental market shft n volatlty. It also makes t possble to follow the development of the excess volatlty over tme. Emprcal results found by Schwert and Segun (99) support such a statstcal model. he modeled normal varances are compared wth realzed monthly return varances, and the dfferences are consdered to be the abnormal varances, as follows: he two mean returns r v t and r c t are essentally the same, but snce cross products are c calculated, resultng n more mssng values, they could dffer. he reason for r t to dffer from v r t could be that the tme seres of consecutve days, used to estmate a monthly varance, nclude mssng values. When the tme seres s lagged one day, and multpled wth the orgnal (not lagged) tme seres to calculate cross products, the days followng a mssng value wll become cross products of mssng values. he number of cross products, therefore, become fewer than the number of days n the orgnal tme seres. For example f there s one day mssng out of the orgnal days, the resultng number of cross products s 8. One s lost due to the laggng c of the seres, and two more are lost due to the mssng day. he mean return r t s calculated by only usng those returns whch result n a cross product that does not result n addtonal mssng values,.e. n the example the 8 returns resultng n an exstng cross product are used. 7

20 eˆ ˆ ˆ σ aι b = σ. (4) m In equaton (4) the star superscrpt ndcates that the vectors of standard devatons come from the event wndow, whle â and bˆ are estmated wth data from the estmaton perod (see Fgure ). he abnormal varance can then be aggregated across stocks, and thereafter tested f t s sgnfcantly dfferent from zero. est statstcs and hypotheses are developed n the same way as for the test concernng sgnfcant abnormal returns. As n the return study, a cross-sectonal correlaton n excess varances could bas the results. herefore equally weghted portfolos are formed out of the stocks havng dentcal opton ntroducton dates. Portfolos are formed before varances are calculated, and they are treated as ndvdual securtes. he tmng of the events of the rsk effect s presented n Fgure. he frst sub-perod s the 44 months estmaton perod, whle the second perod s the event wndow wth months pror to the lstng and months after the lstng. he frst day n month s the lstng day of any stock opton. he pre-lstng perod n the event wndow s used to verfy the predctablty of the model. he post-lstng perod n the event wndow s used to test for excess volatlty n returns. Fgure me Lne for the Event Study E stm aton perod Event wndow me n m onths able shows summary statstcs from the three specfed volatlty models n equaton (3). It can be seen from the table that all estmated parameters are sgnfcant wth one excepton: the slope coeffcent n the varance model. All models produce smlar results. he ordnary least squares (OLS) estmaton of the models n (3) shows that the resduals exhbt a sgnfcant seral correlaton for many stocks. herefore, the OLS estmates of the model coeffcents wll be based. Instead, the methodology developed by Nabar and Park (994) wll be used,.e. mplementng generalzed least squares (GLS) estmates of the parameters n the models, and adjustng for frst order autocorrelaton. he methodology s explctly presented n Appendx B. 8

21 able Summary Statstcs for Volatlty Market Model Regressons he table shows summary statstcs from the regresson models n equaton (3). Separate regressons are conducted usng varances from portfolo returns. Each portfolo conssts of securtes havng the same ntroducton date. In each column the mean of each coeffcent s dsplayed. Columns -5 show the parameter estmates wth ther respectve standard devatons. A frst order autocorrelaton from OLS resduals s presented n column 6, the coeffcent of determnaton n column 7, and n the last column the average skewness n the resduals. Models α σ a b σ b R Skewness σ σ ln σ o facltate the nterpretaton, and due to a hgher R, the model usng market standard devaton as explanatory varable s chosen. he results are essentally the same regardless of the choce of model specfcaton... Idosyncratc Rsk Varance ratos are used n testng for a change n the dosyncratc rsk. he same methodology s also used for the test of changes n the total rsk n such a way that a comparson can be made between the two rsks. When calculatng the varance ratos for the dosyncratc rsk, the varances of resduals from a market model for each stock are computed for a ten-month perod on ether sde of the opton ntroducton date. o get the total rsk effect, the varances of the stock returns are calculated. he varances of the correspondng market returns are also calculated on ether sde of the stock s lstng date. hs s done for each stock separately, usng the same ten-month perod. Dvdng the post-lstng perod varance by the pre-lstng perod varance forms varance ratos (VR). Presented n equaton (5) and (6) are the varance ratos for the dosyncratc and total rsks. he superscrpts I and ndcate whch rsk s consdered, the dosyncratc or total rsk. VR I σ = σ ε, post lstng ε, prelstng (5) he parameters n able appear to dffer consderably dependng on the choce of model, and could potentally lead to a queston of robustness n the results. hs dfference s due to the transformaton of the monthly tme seres, and has no effect on the results whatsoever. All models were tested and the conclusons drawn are the same regardless of the model used. 9

22 VR = σ σ, postlstng, prelstng (6) o control for coexstng shfts n the market rsk, the stock varances n each perod s dvded by the correspondng market varance. he quotent between the stock varances and the market varance s the market-adjusted or standardzed varances. Dvdng the standardzed varances after the lstng by the standardzed varances before the lstng forms the standardzed varance rato (SVR). Presented n equaton (7) and (8) are the varance ratos of the dosyncratc and total rsks. SVR SVR I σ = σ σ = σ ε, postlstng ε, prelstng, postlstng, prelstng σ σ σ σ M, postlstng M, prelstng M, postlstng M, prelstng (7) (8) A VR or a SVR greater than one ndcates an ncrease n the overall rsk n each stock. A rato less than one ndcates a reducton n volatlty. An F-test s performed on each securty s varance rato to test for sgnfcant devatons from one. he medan varance rato s also tested for a sgnfcant devaton from one by a Wlcoxson-sgned rank test...3 Systematc Rsk o test f opton ntroducton has any mpact on the systematc rsk of the underlyng securtes, a market model regresson s estmated over 36 days. Half of the data set occurs before the opton lstng, and the other half after the opton lstng. o adjust for the bas n the coeffcent estmates arsng from thnly traded securtes, the approach of Fowler and Rorke (983) s followed. A dummy varable s ncluded n the model that takes the value one n the perods followng the opton lstng and zero otherwse. More specfcally, the followng model s estmated: R = α + β + γ D R m + β R m + β R m + β R m ( β Rm + β Rm + β Rm + β Rm + β Rm ) + ε + + m + β R + (9) In the regresson model R and Rm represent vectors of stock returns and market returns, respectvely. he superscrpts ++, +,, -, and -- ndcate that each tme seres s shfted to lead or lag two days, one day, or no day. A γ -coeffcent