Three Essays on Derivatives Markets

This thesis consists of three essays. The first essay (chapter two) looks at the impact of derivatives regulation on liquidity and mispricing of US derivatives markets. In particular, we test the hypothesis that Dodd Frank derivative provisions may improve the efficiency of the exchange traded markets due to an increase of arbitrage by traders on the exchange traded markets, as opposed to the OTC markets. We examine the impact of key Dodd Frank events on market activity for financial derivatives (futures and option contracts on US T bonds, Eurodollar futures and options, and S&P 500 Futures contracts) and on foreign exchange derivatives (futures and options contracts on EUROs, British Pounds, and Canadian dollars). First, we look at how liquidity on the markets has been affected. Next, we test for mispricing of derivatives contracts. We find that measured liquidity does fall for US financial futures and options but rises for foreign exchange futures and options subsequent to the introduction of the Treasury guidelines for OTC trading. We also find that the efficiency of the U.S. exchange traded futures markets has improved, as reflected by a reduction in mispricing in the S&P futures contracts; some improvement in pricing efficiency is also shown for nearby Eurodollar futures contracts. These results are consistent with an increase of arbitrage by traders on the exchange traded markets, as opposed to the OTC markets, in contrast to the “noise” model. The second essay (chapter three) provides a description and comparison between OTC and exchange-traded derivatives market activity. It compares the turnover in OTC derivatives among three regions: Americas, Europe, and Asia/Pacific. Similar analysis is also conducted for non-financial customers. The empirical results show that the growth rate of exchange-traded derivatives leads growth rate of OTC derivatives. The conclusion still holds for derivatives of different risk categories. The third essay (chapter four) examines the futures market efficiency of the VIX and the relative merits of the VIX and VIX futures contracts in forecasting future S&P 500 excess returns the future Russell 2000 excess returns, and the future small-cap premium. We find that the current VIX is significantly negatively related to S&P 500 index excess returns and positively related to the Russell 2000 index excess returns. These results suggest that the VIX predicts asset returns based on size based portfolios asymmetrically – with higher (lower) values of the VIX associated with lower (higher) values of small-cap (large cap) returns in the future. However, the VIX and VIX modeled by an ARIMA process are not significantly related to future values of the small-cap premium. In contrast, VIX futures show forecasting prowess for the S&P 500 excess return, the Russell 2000 excess return and the small-cap premium. VIX futures are significantly negatively related to these series. The results for the speculative efficiency of the VIX futures contracts are mixed, however. Overall, the analyses support the hypothesis of informational advantages of the futures markets relative to the spot market in the price discovery process not just for size based asset returns, but on the size premium as well