We find that option listings are associated with a decrease in the variance of the pricing error, a decrease in the adverse selection component of the spread, and an increase in the relative weight placed by the specialist on public information in revising prices for the underlying stocks. We also find that there is a decrease in the spread and increases in quoted depth, trading volume, trading frequency, and transaction size after option listings. Overall, our results suggest that option listings improve the market quality of the underlying stocks.THIS STUDY EMPIRICALLY examines the impact of stock option listings on several aspects of the market quality of the underlying stocks. The motivation for this examination is to provide new and comprehensive evidence on whether stock options, in particular, and derivative securities, in general, have a beneficial or a harmful effect on the market for the underlying securities.We show that the previously documented decrease in the bid-ask spread following option listings is accompanied by an increase in the number of contracts the specialist is willing to trade at the quoted prices (quoted depth). Furthermore, the spread decreases and the depth increases even after controlling for changes in trading volume, volatility, and price. Lower spread and higher depth together provide unambiguous evidence of higher liquidity, and suggest that larger trades can be executed at lower transaction costs after option listings. Consistent with this, we find that the increase in trading volume after option listing is a combined effect of higher trading frequency and larger average transaction size.

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