Do Newly Listed Derivatives Affect the Market Risk Premium in a Thin Stock Market?

Abstract

This study examines the effects on the stock market unitary risk premium and volatility associated with the listing of stock and stock index derivatives in Switzerland. Based on a univariate GARCH (1,1) specification of the stock index variance and a time-varying unitary risk premium representation, we can reject the hypothesis that stock and stock index derivatives listings do not affect the total risk premium. Contrarily to previous empirical evidence, we find that derivatives listings affect both the conditional market returns' variance and the unitary risk premium through structural shocks. The gradual market completion hypothesis is further corroborated in that, cumulatively, the three stock and stock index options futures derivatives listings reduced the unitary risk premium while the marginal impact of each successive listing decayed.JEL Classification: G12, G14. 2 The sign of the bias in the estimated unitary risk premium varies from significatively negative to significatively positive depending on, firstly, the sign of the partial derivative of the indirect utility function with respect to the wealth and the state variable and, secondly, the sign of the covariance between the market variance and the market covariance with the state variable cov σ 2 M,t , σ MF,t . 3 The issue of the optimal smooting method is left for future research.