Empirical essays on financial markets, firms, and derivatives

University dissertation from Stockholm : Företagsekonomiska institutionen

Abstract: This thesis consists of five self-contained studies. The first three investigate the impact of derivatives on the markets for the underlying assets, while the other two examine how and why firms use derivatives. A summary of each of the five studies follows.The first study investigates the relationship between option market activity and cash market volatility on the OMX index. The main concern is whether index option market activity affects the volatility of the underlying market. Option market activity is defined as trading volume divided by open interest, and both total option market activity as well as option market activity broken down by calls and puts is examined. The study contributes by investigating empirical evidence relating to two time periods, each with different market conditions. The results suggest that put option market activity, in contrast to call option market activity, influenced the cash market volatility and that the influence was different for the two periods investigated. However, the findings also indicated that a documented effect of option market activity on cash market volatility can be difficult to interpret.The second study examines expiration day effects of index futures and options on the Swedish market. The expiration day effect arises from the cash settlement procedure that is used to avoid the problems associated with physical delivery. Instead, the cash settlement procedure has reportedly been associated with arbitrageurs scrambling to unwind their arbitrage positions. While the results for the period 1988-1998 indicate that trading volumes on the cash market were significantly higher on expiration days than on other days, no evidence is found suggesting that price distortions occurred. This could be due to the longer settlement period on the Swedish market, compared with that on the Canadian, German, and the US markets, where price distortions have been documented. However, some price distortion may have been experienced for the first half of the sample period, and the cause of this finding is discussed.The third study investigates the impact of warrant and stock option introductions on the Swedish market. The results suggest that warrant introductions have no real effect on the underlying stock. The evidence indicates, on average, that no significant impact occurs on the price, volatility, bid-ask spread, trading volume, or number of actual trading days of the underlying stocks in the year following the warrant introduction. In contrast, the introduction of stock options is found to have a positive effect on the underlying stocks (i.e., volatility and bid-ask spreads are found to decrease). The finding that the introduction of warrants did not result in any changes in the investigated variables for the underlying stocks can be a result of infrequent trading in the warrants.The fourth study provides survey evidence on the use of derivatives among Swedish nonfinancial firms. The evidence for the Swedish firms is also compared with earlier findings for the US and New Zealand. The results show that (1) firms in Sweden used derivatives to the same extent as firms in New Zealand did, but to a larger extent than US firms did; (2) the usage of derivatives was more common among larger than among smaller firms; (3) the principal use of derivatives was for hedging purposes and those firms that engaged in speculative activity tended to be larger rather than smaller firms; and (4) lack of knowledge about derivatives within the firm was the issue of most concern for financial directors.The fifth and last study examines why widely held firms engage in hedging activities. The study contributes to the previous research by not only examining firm characteristics associated with use of currency derivatives in general, but also by analyzing the type of foreign exchange exposure that is hedged. More specifically, the association between firm characteristics and hedging of translation exposure and transaction exposure is investigated. This is of interest since translation exposure and transaction exposure tend to affect firms differently. The results show that transaction exposure hedging with currency derivatives was related to variables that represent indirect costs of financial distress and the underinvestment problem associated with costly external financing. Notably, translation exposure hedging with currency derivatives was unrelated to these proxy variables. The results suggest that firms hedge transaction exposure with currency derivatives to increase firm value, while there was no evidence that translation exposure hedges are used for that reason.

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