FIN-01-038

Margin Rules, Informed Trading in Derivatives,and Price Dynamics

March, 2001

Kose John, Apporva Koticha, Ranga Narayanan and Marti G. Subrahmanyam

ABSTRACT

We analyze the impact of option trading and margin rules on the behavior of informed traders and on the microstructure of stock and option markets. In the absence of binding margin requirements, the introduction of an options market causes informed traders to exhibit a relative trading bias towards the stock because of its greater information sensitivity. In turn, this widens the stock's bid-ask spread. But when informed traders are subject to margin requirements, their bias towards the stock is enhanced or mitigated depending on the leverage provided by the option relative to the stock, leading to wider or narrower stock bid-ask spreads. The introduction of option trading, with or without margin requirements, unambiguously improves the informational efficiency of stock prices. Margin rules improve market efficiency when stock and option margins are sufficiently large or small but not when they are of moderate size.

Classification: G12, G14

Kose John
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0337
Fax: (212) 995-4233
Email: kjohn@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~kjohn

Apoorva Koticha
Institution: Citigroup

Ranga Narayanan
Institution: Case Western Reserve University, Weatherhead School of Management, Cleveland, OH 44106
Telephone: (216) 368-2142
Fax: (216) 368-4776
Email: rxn14@po.cwru.edu

Marti G. Subrahmanyam
Institution: Stern School of Business, New York University, 44th West 4th Street, New York, NY 10012
Telephone: (212) 998-0348
Fax: (212) 995-4233
Email: msubrahm@stern.nyu.edu
Homepage:http://www.stern.nyu.edu/~msubrahm

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