Volatility Derivatives and Market (Il)liquidity


Speaker:Bart Z Yueshen, Insead
Date: Tuesday 26 March 2019
Time: 13:45
Location: Kolade Teaching Room

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.