Volatility Derivatives and Market (Il)liquidity
Finance
Further details
This paper studies how volatility derivatives—options, variance swaps, etc.— affect the underlying
asset’s liquidity. In equilibrium, asymmetrically informed investors rationally bet on the underlying
volatility using the derivatives. Such bets can widen the wedge across investors’ expected marginal
utility, amplifying the liquidity risk. Further, investors delta hedge their volatility bets. As a
result, in the underlying market, price impact lowers (possibly non-linearly) because delta hedging
dilutes informed trading, suggesting higher liquidity. In contrast, price reversal exacerbates because
delta hedging creates additional price pressure, suggesting lower liquidity. The model warns such
disconnection of empirical illiquidity measures from liquidity risk premium.
