Essays on Derivatives and Liquidity

Abstract: This dissertation contains four essays in which derivatives markets are studied in relation to three related topics in financial economics: asset pricing, market microstructure and risk management.Essay I studies the role of relative option liquidity in explaining the volatility smile.We find that option happiness (the steepness of the volatility smile) is significantly dependent on the relative liquidity between option series with different moneyness. This relationship is robust to relative option liquidity measures based on bid-ask spreads, option price impacts, and option order book imbalances.Essay II examines the consequences of a unique event on expiration-day effects, namely the synchronizing of the expiration days of different derivatives contracts in Sweden. The results show that there is no significant intensification of expiration-day effects due to the event, despite the quadruple witching expirations after the change.Essay III investigates the characteristics of the limit order book in an index futures market, and examines the intertwined dynamics between trading patience, order flows and liquidity. The results show that, most of the time, the limit order book displays a hump shape. Bid and ask prices tend to move in the same direction. Higher trading patience and higher order arrival rate generates higher liquidity. Moreover, liquidity has a feedback effect on trading patience and order arrival rate. This confirms that some traders may time their arrivals in real time according to market conditions and establish their trading strategies accordingly.Essay IV is the first to study the Chinese gold market, analyzing hedging strategies utilizing the newly launched Shanghai gold futures. The results show that hedging with gold futures reduces the variance by about 88% in its first two years of existence. Furthermore, the simpler regression hedge outperforms the more complicated bivariate GARCH hedging strategies.