Does the Liquidity of Underlying Stocks Affect the Liquidity of Derivatives? Evidence from a Natural Experiment *

Abstract

This paper documents a significant positive impact of the liquidity of underlying stocks on the liquidity of derivative securities on the basis of a sample of options and derivative warrants traded in Hong Kong. The study relies on an exogenous change in the liquidity of underlying stocks, namely, the tick size reduction implemented by the Hong Kong Stock Exchange (HKEx), which significantly reduces the bid-ask spreads of underlying stocks. The bid-ask spreads of derivative securities are also significantly reduced, especially those less liquid and with a greater inventory risk. The results of the paper are consistent with the derivative hedging theory of Cho and Engle (1999) and shed light on the sources of the liquidity of derivative securities.