Determinants of liquidity for bank-issued options: Evidence from the Australian covered warrants market

Giovanni Petrella* Reuben Segara** This draft: August 31, 2008 Abstract In this paper we apply a structural model to investigate the main determinants of the bid-ask spread for Australian covered warrants. These instruments are also referred to as bank-issued options. They have been mainly promoted to retail investors, and have attracted the interest of market practitioners and academics, based upon their tremendous growth in trading volume across several stock exchanges. Three main determinants are found that significantly contribute to the size of the warrant bid-ask spread. The first two determinants relate to the inventory risk management practices of market makers and include the initial cost of setting up a delta neutral portfolio, as well as rebalancing costs to keep the portfolio delta neutral. This particular result validates that the spread of the warrants is positively related to the spread of the underlying assets. The last determinant relates to adverse selection costs, where market makers incorporate a reservation bid-ask spread to protect themselves from scalpers. The empirical analysis also shows that a higher number of warrant issuers does not lead to a narrower warrant spread. This evidence indicates that warrant execution costs do not benefit from the presence of a large number of issuers making market on the same underlying asset. Keywords: covered warrants; options; liquidity; bid-ask spread. JEL Classification: G10; G20; G24.
The authors would like to acknowledge the research support of the Australian Stock Exchange (ASX) and the Securities Industry Research Centre of Asia-Pacific (SIRCA) for the use of data in this research. Thanks must go to all participants that provided useful comments and suggestions at presentations held at the University of Sydney, the Capital Markets Cooperative Research Centre and the Research and Development Division of the ASX. For correspondence, Giovanni Petrella, Associate Professor of Banking, College of Banking, Finance and Insurance, Catholic University, Largo Gemelli 1, 20123 Milano (Italy), e-mail giovanni.petrella@unicatt.it.
*

**

Catholic University, Milano, Italy, e-mail giovanni.petrella@unicatt.it. University of Sydney, Sydney (NSW), Australia, e-mail R.Segara@econ.usyd.edu.au.

I.

INTRODUCTION

Covered warrants are transferable instruments that confer to the holder the right to buy or sell a specific underlying claim on (or before) a predetermined date.1 They are optionlike securities traded without clearinghouse intervention and mainly issued by banks. They share with options mechanics and pricing principles, but differ from standard exchange-traded options for the following reasons: they are traded as spot instruments (i.e., without initial and variation margins); they do not allow parties other than the issuer to be short (i.e., to write options); of their longer maturities; of the lower value of their minimum trading size; of their higher premiums.2 Covered warrants can be best described as retail investordriven securities, as issuers meet retail investors demand for derivatives by creating securitized options, which are easy-to-trade and do not require margin accounts. The objective of this study is to examine the determinants of liquidity as measured by the bid-ask spread on the Australian covered warrants market. An examination of the determinants of covered warrant bid-ask spreads provides insights relevant to understanding transaction costs borne by retail investors who trade options. Few studies have examined the determinants of bid-ask spreads on derivative markets compared to the voluminous amount of research produced for stock markets. These latter studies have mainly concentrated in United States (US) markets and have consistently shown that the bid-ask spread on stocks compensate market makers for adverse selection, inventory and order processing costs.3 However, the empirical evidence as to the main determinants of the bidask spread in the options and warrants market is mixed (see Section 2).

The underlying claim may be securities such as shares, baskets of shares, unit trusts, foreign currencies or share price indices. Several empirical studies have found higher premiums on covered warrants than for comparable traded options. This result has been reported in Australia (Chan & Pinder, 2000), Netherlands (Horst & Veld, 2003), Germany (Bartram & Fehle, 2007) and Spain (Abad & Nieto, 2007). These studies include: Garman (1976), Stoll (1978), Ho & Stoll (1981), Glosten & Milgrom (1985), Kyle (1985), Easley & OHara (1987), Glosten (1987), Glosten & Harris (1988), Huang & Stoll (1997), and Madhavan, Richardson, & Roomans (1997).

This study contributes to the previous literature in three ways. First, our study test whether the structural model developed by Petrella (2006) to explain bid-ask spreads on the Italian covered warrants market also holds for Australian covered warrants. This structural model is based on option market making costs (initial hedging, rebalancing, and order-processing costs), and incorporates a reservation bid-ask spread that option market makers apply to protect themselves from scalpers. Second, the effect of competition across different warrant issuers (i.e., intra-market competition) is explicitly accounted for. The inclusion of this explanatory factor is important as several studies have shown that competition has an effect on option liquidity. Mayhew (2002) finds that options listed on multiple exchanges have narrower spreads than those listed on a single exchange. De Fontnouvelle, Fishe, & Harris (2003) also find significant decreases in effective and quoted bid-ask spreads after multiple listing. Consistent with previous studies, Battalio, Hatch, & Jennings, (2004) document a significant improvement in market quality following the increased competition associated with multiple listing. Batram, Fehle & Shrider (2007) also show that bid-ask spreads on either the option or warrant market are lowered by competition from the other market. Third, we employ a larger and richer data set than previous studies, which consists of the entire order book for the Australian covered warrants market. This allows us to accurately examine the relevance of the order flow in determining warrant spreads on a continuous basis. Examining the liquidity of the covered warrants markets is justified, especially given its significant growth around the world in recent years. According to the World Federation of Exchanges (WFE) statistics, covered warrants trading volume was approximately USD 100 billion in 2002 and over USD 1,423 billion in 2007. Over the same period, the trading volume in the Australian covered warrants market had grown by approximately 10 times from USD 1.7 billion to USD 17.4 billion. Covered warrants are also actively traded on many European (e.g., Germany, Italy, Spain, Switzerland, and United Kingdom) and Asian markets (e.g., China, Hong Kong, Singapore, Malaysia and Taiwan).

The remainder of this study is organised as follows. Section 2 begins with a concise literature review that examines the determinants of the bid-ask spread in option and covered warrant markets. Section 3 describes the institutional details of the Australian covered warrant market, and the data used in the empirical analysis. Section 4 discusses variables definition and empirical results. Summary and conclusions are provided in the last section.

II.

LITERATURE REVIEW

The literature on the determinants of bid-ask spreads in the options markets include Jameson & Wilhelm (1992), Cho & Engle (1999), Kaul, Nimalendran & Zhang (2004); and for covered warrant markets, Petrella (2006) and Whalley (2008). Jameson & Wilhelm (1992) find that option market makers on the Chicago Board of Options Exchange (CBOE) bear option-specific inventory risks, which significantly affect the option bid-ask spread. These risks include the inability of option market makers to continuously rebalance their inventory position (i.e. discrete rebalancing risk) and the uncertainty about the return volatility of the underlying stock (i.e., stochastic volatility risk). The authors highlight the importance to account for these inventory risks in determining option spreads, especially since they are not present in the risk for market makers in stocks. This salient fact is offered as an explanation for the relatively large percentage spreads observed in the options market compared to the underlying stocks (Vijh, 1990). By contrast, Kaul et al. (2004), using more recent data, find that discrete rebalancing risks for CBOE options only account for 6.9% of the spread. They interpret this to mean option market makers hedge their positions, but do not have to incur large rebalancing costs either because they may not hold their positions very long or they can effectively diversify their portfolios. The extent to which adverse selection costs plays an important role in determining option spreads is also unclear in the extant literature. Vijh (1990)

examines the effects of large option trades on the CBOE. Based on a sample of 146 large option trades, the author finds that the adverse selection component has only a small influence on option liquidity. This result is later confirmed by Cho & Engle (1999). By contrast, Kaul et al. (2004) find that the adverse selection component of the underlying stock bid-ask spread explains a significant fraction of the spread for CBOE options. Petrella (2006) empirically studies the main determinants of the bid-ask spread on the Italian covered warrants market. He finds that the initial hedging costs and rebalancing costs are positively related to the warrant proportional bid-ask spread. Empirical evidence is also found that the reservation spread (or the minimum spread required by market makers to protect them against scalpers) significantly affects the warrant bid-ask spread. These results are interpreted to mean that warrant market makers continuously hedge their option positions by rebalancing (i.e., trading) in order to keep their portfolio delta-neutral and do not fear trading with informed traders, because their positions are fully hedged.4 This result is consistent with the theoretical model developed by Whalley (2008), which demonstrates that the size of covered warrant spreads is primarily set to compensate market makers for their hedging costs and inventory risk.

III.
A.

INSTITUTIONAL BACKGROUND AND SAMPLE DESCRIPTION

Market Structure

In 1991, fifteen years after the introduction of the first exchange traded option (ETO), the Australian covered warrants market commenced. Equity covered warrants are issued by third parties (usually investment banks), other than the underlying company, who at least originally were supposed to cover (i.e., to hedge) their short position. A call (put) equity warrant gives the holder the right, but not the obligation to buy (sell) the underlying stock at a predetermined price

Hedging risk is accounted for in the market maker profit.

on or before the expiry date. For this right, the warrant buyer pays the warrant issuer a premium, which represents the market price of the warrant. Trading in warrants is sourced primarily from retail investors taking a speculative bet. This category of investors is unfamiliar with the options market and lacks the necessary cash required to manage a margin-lending account. These investors use warrants to minimise the proportion of their capital at risk, while taking leverage gains. Institutional investors if they do not use ETO can also gain broad exposure to foreign equity markets, hedge domestic market exposure, or obtain an investment in a particular market segment through warrants. Warrants are traded on the Stock Exchange Automated Trading System (SEATS) in the same manner as shares and have typical expiry terms ranging from three to eighteen months, with the length likely to be twelve months.5 Normal trading in SEATS takes place on a continuous basis from 10:00 to 16:00 on Monday to Friday. In order for third parties (hereafter termed issuers) to be granted trading status from the ASX, they are required to facilitate a market in the warrants issued, but are not obligated to do so. Hence, the equity warrants market can be seen as a hybrid market, in which both limit order traders and an unofficially designated dealer (i.e., the warrant issuer) establish prices. Issuers play an important role in the covered warrants market. Though banks are not obliged to facilitate a market in their warrants issued, they have a material interest in ensuring a liquid and efficient market for the warrants that they have issued. Warrant issuers have developed a reputation for ensuring investors a liquid market place through active participation in the secondary market.6 These trading activities aimed at improving market liquidity have encouraged the use of warrants from smaller investors. Warrants issuers also have the right on issue to

SEATS is a competitive and transparent electronic order book. Since 2 October 2006, trading of all ASX securities is conducted on the Click-XT system, also known as the Integrated Trading System (ITS). The new trading system has not affected the way in which securities are traded. ASX Market research on the warrants market revealed that during 1996 the specific issuer accounted for 42% to 57% of turnover for three of the most actively traded warrant series.

create further warrants, and to purchase existing warrants that may be held, resold or cancelled.

B.

Sample

The data used in this study is provided by the Australian Stock Exchange (ASX). Underlying stock and covered warrant data are extracted from the high frequency SEATS database maintained by the Securities Industry Research Centre of AsiaPacific (SIRCA). The SEATS database provides full details of all stock and equity warrant orders and trades placed on the ASX. These records provide details of security code, price, volume, date, broker and time to the nearest one hundredth of a second for every order and trade. An ASX Signal E database is used to obtain the listing dates, expiration dates, exercise price, types (call or put), style (European or American), conversion ratio and issuer for all warrants traded.7 The sample period spans from November 4, 1995 to December 31, 2004. Table 1 provides descriptive statistics for all covered warrants included in our sample. There are substantially more call warrant series (70.5%) relative to put warrant series (29.5%) over the entire sample period. This evidence suggests that the demand for call warrants on the ASX has consistently exceeded that for put warrants and may be explained by the greater ease to place long bets than short bets for unsophisticated retail investors. However, from the year 2000 onwards, there has been a steady growth in the number of put warrant series relative to call warrant series offered to the market. The increase in put warrant series is related to the bear market period that encourages short bets. The full sample consists of 432,313 observations and corresponds to 3,261 covered warrants.

The conversion ratio is the number of warrants that must be exercised to take one unit of the underlying asset. While trading prices are quoted on a per warrant basis, the exercise price is quoted on a per asset basis. Consequently, the conversion ratio affects the price of warrants, but not the exercise price.

IV.
A.

EMPIRICAL ANALYSIS
Variables Definition

Liquidity can be measured in different ways. Quoted bid-ask spread is usually considered as an appropriate metric for measuring execution costs. However, quoted spread does not always reflect actual execution costs. Petersen &

Fialkowski (1994) introduce the concept of effective spread that takes into account the possibility of transaction prices different from the quoted bid and ask prices. In fact, especially in non-electronic quote driven markets, trades also occur inside posted bid and ask quotes: thus, quoted spread overestimates the spread investors actually pay. By contrast, in electronic order driven markets trades normally occur at posted quotes: thus, quoted spread should be in principle equal to the effective spread. However, when the size of the order is larger than the inside posted depth, the order walks up the limit order book and trades also occur at non-best prices, by implying in such cases that the effective spread is larger than the quoted spread. In order to identify the appropriate metric (quoted spread vs. effective spread) for measuring transaction costs, we compare the actual trade size with the depth available on the book at best quotes. We compute the monetary value of the inside posted depth (MVIPD) as follows:
MVIPD = M t AQt + BQt 2

[1]

where AQt ( BQt ) denotes the number of warrants associated to the best ask (bid), and M t the quote midpoint. In our sample, the average (median) value of the inside depth is AUD 11,798 (7,839), while the average (median) trade size is AUD 8,929 (3,482). Both the average trade and the median trade have been satisfied by best quotes only, without implying the order walking up the book.

We, thus, conclude that the quoted bid-ask spread is an appropriate statistic to measure covered warrants execution costs on the Australian warrants market.8 In the empirical analysis, to get a metric that is comparable across different warrants, we use a percentage version of the quoted spread. The percentage quoted bid-ask spread ( PBASt ) has been computed as follows:

PBASt = 200

At Bt At + Bt

[2]

where At ( Bt ) is the option ask (bid) quote at time t. Table 2 provides summary statistics for the percentage quoted bid-ask spread. In Panel B, the full sample of daily spread observations is partitioned by quartile of time-to-maturity (TTM): we find that both the average and the median percentage spread monotonically decline as the maturity increases. This evidence is consistent with at least two explanations. First, covered warrants traders can only assume long positions (given that the issuer only has a short position) and, thus, have negative theta exposition. Therefore, covered warrants traders tend to use far-from-expiring covered warrants in order to reduce the negative impact of the theta effect. A concurrent explanation of this finding relates to the price level of close-to-expiration warrants: the more the maturity approaches, the lower is the time value of the option and therefore the lower the price level. Tick size may adversely affect the percentage bid-ask spread, especially for very low price levels. Moreover, in order to facilitate warrants liquidity and marketability, issuers tend to set low conversion ratios, by implying low warrant prices, and this again is usually related to larger percentage spreads.9

In unreported analysis we also partition the sample by quartiles of time-to-maturity and compute the ratio of the limit order book depth (MVIPD) to the trade size in monetary value. This ratio ranges from 1.1 to 2.3 based on average values and from 1.7 to 2.8 based on median values. In addition to this univariate analysis, in the regression analysis presented in Section IV.B. the relationship between spread and time-to-maturity is explored by explicitly controlling for the impact of trading volume.

Table 2 also investigates the relationship between warrants bid-ask spread and moneyness in Panel C. Out-of-the-money warrants exhibit larger bid-ask spread than in-the-money warrants. Possible explanations for this finding partly overlap with those put forward for the relationship between time-to-maturity and spread. In-the-money options, like far-from-the-expiration options, tend to have higher price levels than out-of-the-money options. In fact, both factors positively affect option value: moneyness affects option intrinsic value, time-to-maturity affects option time value. Panel D of Table 2 reports bid-ask spread statistics partitioned by quartiles of price levels: the bid-ask spread declines as the price level increases. This finding is consistent with the evidence relative to the behavior of the bid-ask spread by moneyness and quartiles of time-to-maturity: warrants with lower prices (and larger spreads) are typically out-of-the-money and/or close-to-expiration. We consider the following factors to explain warrant bid-ask spread: hedging costs, order processing costs, market makers expected profits. In setting the bid-ask spread, a warrant market maker takes into account hedgingrelated costs. To minimize risk exposure, a warrant market maker wishes to hold a portfolio that is insensitive to small changes in the value of the underlying asset (i.e., a delta neutral portfolio). To keep his/her portfolio delta neutral, the market maker engages in hedging transactions in the underlying stock. These trades involve for the market maker incurring in transaction costs that will be covered with the warrant bid-ask spread. Hedging involves an initial cost of setting up a delta neutral position, as well as the costs of rebalancing the portfolio at discrete times (Kaul et al., 2004). Initial hedging costs ( IHCt ) can be modeled as follows:
IHC t = BAS tS t M t crt

[3]

10

where BAS tS is the underlying asset quoted bid-ask spread at time t, t is the warrant delta at time t, crt is the warrant conversion ratio at time t. Changes in the underlying price demand adjustments in the market maker portfolio composition. To keep the position delta neutral at all times, the market maker needs to appropriately rebalance his/her portfolio. However, continuous rebalancing is costly. If the market makers portfolio is short options (either calls or puts), the market maker to remain delta neutral at all times must rebalance the hedge by buying the underlying asset when the underlying asset price goes up and selling it when the price goes down. This sort of anti-stabilization trading implies that a delta neutral position that is short (long) options will lose (gain) money when the price of the underlying is volatile. Thus, assuming that the market maker is short, rebalancing costs to hold a delta neutral position are higher when the warrant gamma is higher and the price of the underlying asset is highly volatile. In fact, the second order effect10 in the change of the market maker portfolio value ( V ) implied by a change in the value of the underlying stock can be computed as follows:
dV = c 1 ( S ) 1 1 2c (dS ) 2 = (dS ) 2 = (dS ) 2 2 2 S 2 S 2

[4]

where d indicates the change in the variable level, S is the underlying asset price, c is the warrant price. As a proxy for the rebalancing costs, we thus consider:
RC t = tS

[5]

where tS is the standard deviation of the underlying asset return on day t. We expect, as a consequence of the previous discussion, a positive relationship between RC t and warrant bid-ask spread.

11

Dealers making market on several warrants with the same underlying stock may benefit from economies of scope in the hedging activity. As long as market makers are able to diversify their portfolio of covered warrants, explicit (i.e., trade-related) hedging costs are reduced. Therefore, we expect that the number of substitute covered warrants (that is, on the same underlying asset) per issuer should be negatively related to the bid-ask spread. In principle, as the number of substitute covered warrants increases, implicit hedging possibilities should increase and, thus, the costs of making market should decrease. Order processing costs are made up of exchange fees, bookkeeping and back office costs, the market makers time and effort, and other costs of doing business. We expect order processing costs to be negatively related to the volume of trading for two reasons. First, because (at least part of) these costs are fixed, order processing costs per trade should be lower for more heavily traded covered warrants. Second, limit orders are positively correlated with volume. They directly enter the order book and may act as a substitute of the market maker in providing liquidity. The competitive pressure from these orders should be reflected in lower spread. In summary, an increase in volume will lower the spread by reducing the market maker costs per trade, and simultaneously attracting limit order traders. The size of the gross expected profit component of the spread depends on the degree of competition in providing liquidity. A higher level of actual competition among market makers or a higher degree of market contestability11 should reduce the expected profit component and, thus, the bid-ask spread. Covered warrants on the Australian market are issued by several financial institutions. Holding constant all the relevant characteristics (e.g., underlying asset, maturity, strike price, exercise style), a covered warrant issued by a financial intermediary is a perfect substitute for the comparable covered warrant issued by another intermediary. By assuming that all covered warrants on the same underlying are

10

Delta hedging eliminates the first order effect.

12

in competition, we consider the total number of covered warrants on the same underlying asset as a proxy for the intensity of market competition.12 Finally, we also need to control for other characteristics of the covered warrants that might affect the size of the bid-ask spread. As shown in Table 2, bid-ask spread is related to time-to-maturity, moneyness and price level. First, to control for time-to-maturity, we consider the number of trading days between the current date and the expiration date. The evidence on the relationship between spread and time-to-maturity in a multivariate framework is not conclusive. Different studies provide constrasting evidence: the relation has been found to be positive (George & Longstaff, 1993), negative (Fleming et al., 1996) and insignificant (Kaul et al., 2004). Second, to control for moneyness, we consider the relative difference between the current stock price S t and the present value of the strike price Xe r (T t ) :
S t Xe r (T t ) S M t = r (T tt ) St Xe St if if call [ 6] put

In previous studies, moneyness has been found to be consistently negatively related to the bid-ask spread (George & Longstaff, 1993; Fleming et al., 1996; Kaul et al., 2004). Third, to control for the price level, we consider the relative tick size (i.e., the ratio between tick size and midquote).

11

12

According to Neal (1987) findings, potential competition is as effective as actual competition in lowering trading costs for equity options. More precisely, the variable considered in the regressions as a proxy for competition intensity does not include the number of covered warrants issued by the same financial institution. Consider, for example, a covered warrant issued by Macquarie Bank on Rio Tinto stock: the number of substitute covered warrants includes all covered warrants issued by Macquarie on Rio Tinto, whereas the market competition variable considers all covered warrants issued by any intermediary on Rio Tinto stock except those issued by Macquarie.

13

Lastly, we control for scalping risk. Petrella (2006) shows that option market makers lose money when trading with successful scalpers. Scalpers are traders who establish and liquidate option positions quickly, even for very small gains in relative terms. Scalpers trade very frequently during the day to make intraday profits without carrying inventory overnight. They do not exploit arbitrage opportunities between option and underlying asset prices, they simply try to profit from intraday price trends. On the other side, option market makers try to neutralize scalpers profit opportunities when setting the bid-ask spread. Specifically, given that scalpers take liquidity from the book using market orders, a scalper in long position profits from the difference between the bid price at the time of his/her sale and the ask price at the time of his/her buy. Formally, the profit for a long position scalper is positive when: Bt +1 At > 0 where At ( Bt +1 ) is the option ask (bid) quote for trade t (t+1). The absolute change in the option bid quote implied by a one tick positive change in the underlying can be computed as follows: Bt +1 Bt = T S t [8] [7 ]

where T S is the current tick size of the underlying asset and t is the option delta at time t. By substituting equation [8] in equation [7], the profit condition for a scalper can be rewritten as:

T S t > At Bt

[9]

Therefore, the reservation (i.e., minimum) bid-ask spread at time t ( RBAS t ) is:
RBAS t = At Bt = T S t

[10]

14

In summary, to protect from scalping, an option market maker has to quote a bidask spread at least as large as the tick size of the underlying stock multiplied by the absolute value of the option delta. Table 3 summarizes variables and proxies used in the regressions specifications, along with the expected impact on covered warrants bid-ask spread.

B.

Panel Regressions

We estimate a panel specification with random effects. F-test of the null hypothesis that the constant terms are equal across covered warrants has been rejected. This result implies that pooled OLS would produce inconsistent estimates and, consequently, we need to take into account warrant-specific heterogeneity. Next, we perform an Hausman test of the null hypothesis that the extra orthogonality conditions imposed by the random effects estimator (i.e., the regressors are uncorrelated with the warrant-specific effect) are valid. Hausman test does not reject the null hypothesis of a difference between random effects and fixed effects estimators. We thus estimate random effects models, which are both consistent and efficient. Lastly, following Petersen (2008), we compute t-statistics based on Rogers standard errors clustered by warrant to account for heteroskedasticity and nonzero (warrant-specific) autocorrelation in the error term.13 Table 4 shows estimation results for four specifications: a baseline specification (model [1]) that only includes hedging costs (initial and rebalancing costs), as well as moneyness and time-to-maturity as control variables; next we incorporate quadratic terms for moneyness and time-to-maturity in model [2] to control for non linear effects; trading volume and relative tick size in model [3]; and the number of substitute options and market competition in model [4]. We also

13

Petersen (2008) shows that, although widely used in the finance literature, in the presence of within cluster correlation (e.g., residuals correlated across observations over time for a given security), standard errors are biased when estimated by OLS, White, Newey-West, or FamaMacBeth methodologies.

15

estimate an extended version, for each of the previous specifications that include the reservation spread set by market makers to protect from scalpers. Table 5 presents the estimation results for the extended versions (models [5] to [8]) that control for scalping risk. Initial hedging costs (IHC) are highly significant and with a positive sign, as expected. Sign and significance of IHC parameter are unaffected in all the specifications we estimate. This result provides two interesting insights. First, it indicates that warrants market makers delta hedge their positions in providing liquidity to the market. Second, warrants trading costs are related to the underlying stock trading costs. In fact, initial hedging costs are computed as the product of warrant delta (in absolute value) and underlying asset bid-ask spread. Consequently, the bid-ask spread of covered warrants is positively related to the bid-ask spread of underlying assets. Option market makers should continuously adjust their portfolio in order to keep a delta neutral position. We consider a proxy for rebalancing costs (RC) based on warrant gamma and underlying stock return volatility. The estimated parameter for RC has a positive sign in all the specification and, except for model [3] and [4],14 is highly statistically significant. Therefore, warrant bid-ask spread

increases with the magnitude of rebalancing costs, as proxied by the option gamma and the underlying asset volatility. As for the control variables, moneyness (M) is not statistically significant both in its linear version and in the quadratic version. By contrast, the estimated coefficient for time-to-maturity (TTM) is negative and statistically significant: far-from (close-to)-expiration warrants have lower (higher) percentage spreads than close-to (far-from)-expiration ones. Moreover, the quadratic term for TTM

14

Our proxy for rebalancing costs (RC) is no more significant when we include trading volume and relative tick size in the estimated specification. We believe that the relative tick size variable which is highly significant partly captures rebalancing costs given that the higher is the relative tick size (i.e., tick divided by warrant price) the larger is the return or price swing (and consequently the rebalancing costs) implied by just a one tick change in the price of the warrant.

16

is positive and also statistically significant: as long as TTM increases, warrant bid-ask spread declines at a decreasing rate. The trading volume (TV) variable, measured as the number of trades,15 has a negative sign coefficient and is statistically significant in any specification. This result is consistent with the standard market microstructure hypothesis that order processing costs decrease as the trading volume increases. The relative tick size parameter is highly significant and positively affect the magnitude of the bid-ask spread. Option prices may reach very low levels when maturity approaches (as the time value tends to zero) and for deep-out-of-themoney options (as the intrinsic value is zero). The size of the tick may thus imply larger percentage bid-ask spreads. Interestingly, R-squared between strongly

increases with the inclusion of the tick size variable. Between-effects regressions are estimated on warrant averages, therefore tick size is very useful in explaining bid-ask spread variations across warrants or, equivalently, in predicting crosssectional spread differences across warrants. Market makers can in principle reduce hedging costs through diversification across different warrants on the same underlying asset (that is, offsetting opposite delta exposures in call and put warrants). Thus, we expected a negative

relationship between the number of covered warrants issued by the financial institution and the bid-ask spread. However, the coefficient estimated for the number of substitute warrants (SW) is not statistically significant. The expected negative relationship derives from the idea that implicit hedging possibilities increase as long as the number of warrant issued by an investment bank on the same underlying asset also increases. In fact, this idea assumes that the order flow is cross-sectionally uncorrelated. By contrast, retail investors tend to assume the same bet on a specific underlying asset in a certain period. This herding behavior generates a one-way order flow and actually reduces implicit hedging
15

Jones et al. (1994) suggest that number of trades is a more significant explanatory variable for bid-ask spread than volume either measured by the number of shares traded or the value of shares traded.

17

possibilities. This argument might explain the insignificant relationship between the number of substitute warrants and the bid-ask spread. We also expected the level of market competition (MC), proxied by the number of covered warrants issued by competitors, to affect negatively the size of the warrant bid-ask spread. However, the estimated parameter is not statistically significant. This evidence is consistent with at least two explanations. First, the number of warrants issued by competitors on the same underlying asset might be inappropriate to measure the intensity of market competition. Issuers of covered warrants choose underlying assets who attract the trading interest of retail investors. This argument implies that warrants are concentrated on relatively few underlying assets (and, consequently, the number of warrants issued on the same underlying asset tends to be relatively high). However, at the same time, issuers also try to differentiate the characteristics (e.g., strike price, maturity, conversion ratio) of the warrants that they issue. This strategy makes the warrants on the same underlying asset only imperfect substitutes. In Table 5 we present estimation result for model specifications that include the reservation spread. Two comments are in order when comparing these estimates with those reported in Table 4. First, signs and significance levels for the explanatory factors included in models [1] to [4] are generally confirmed in models [5] to [8]. The extended specifications confirm the robustness of the previous coefficients estimates. Results are stable either with or without the reservation spread variable. Second, the estimated coefficient for the reservation spread is positive and statistically significant and, importantly, with the inclusion of this variable the overall significance of the models as well as the goodness-offit increase. Models with the reservation spread perform much better than those without: Wald test results show that the estimated coefficients are jointly more significant in models [5] to [8] then in models [1] to [4]. This difference is accounted for by the inclusion of the reservation spread. In summary, empirical evidence strongly supports the significance of the reservation spread to explain

18

covered warrants bid-ask spread and also indicates that market makers actually take into account the reservation spread in setting the quoted spread.

V.

SUMMARY AND CONCLUSIONS

Covered warrants are bank-issued options that have been mainly used by retail investors for speculative reasons. The tremendous growth of this market has placed bank-issued options to the attention of both market practioners and academics. This study investigates the determinants of bid-ask spreads for Australian covered warrants. Three main determinants examined to explain warrant bid-ask spread include hedging costs, order processing costs, and intramarket competition across warrant issuers. Hedging costs incurred by market makers to hold delta neutral portfolios is found to be a main determinant of the warrant spread. This result also confirms the relation between the option and underlying asset: The spread of the option is positively related to the spread of the underlying asset (see Kaul et. al, 2004). Order processing costs represents an order processing fee charged by market makers for standing ready to match orders, including physical communications and other costs of doing business. Trading volume is interpreted as capturing the effects of a fixed component to order processing costs, and found to be negatively related to the warrant spread. This is consistent with the idea that market maker costs per trade are reduced with an increase in trading volume, resulting in a narrower warrant spread. No evidence is found that shows market competition among warrant issuers is negatively affect the size of the bid-ask spread. This indicates that the size of the gross expected profit component of the warrant spread is unrelated to the degree of competition. Several other independent variables are used to control for known characteristics of covered warrants that affect the size of the bid-ask spread. These include the time-to-maturity, moneyness, price level, and scalping risk. A negative relationship between time-to-maturity and warrant bid-ask spreads is found. In

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terms of moneyness, out-of-the money warrants exhibit larger bid-ask spreads than in-the-money warrants. The price levels of covered warrants are also found to be negatively related to their spreads. Our study also finds that scalping risk faced by market makers plays an important role in explaining the bid-ask spread of warrants.

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REFERENCES
Abad, D., Nieto, B., 2007. The unavoidable task of understanding warrants pricing, Working paper Bartram, S.M., Fehle, F., 2007. Competition without fungibility: Evidence from alternative market structures for derivatives. Journal of Banking and Finance 31, 659-677. Battalio, R., Hatch, B., Jennings, R., 2004. Toward a national market system for U.S. exchange-listed equity options. Journal of Finance 59, 933-962. Chan, H.W., Pinder, S.M., 2000. The value of liquidity: Evidence from the derivatives market. Pacific-Basin Finance Journal 8, 483-503. Cho, Y., Engle, R., 1999. Modeling the impacts of market activity on bid-ask spreads in the option market. NBER Working Paper # 7331. Cambridge (MA), National Bureau for Economic Research de Fontnouvelle, P., Fishe, R., Harris, J., 2003. The behavior of bid-ask spreads and volume in options markets during the competition for listings in 1999. Journal of Finance 58, 2437-2464. Easley, D., O'Hara, M., 1987. Price, trade size, and information in securities markets. Journal of Financial Economics 19, 69-90. Fleming, J., Ostdiek, B., Whaley, R., 1996. Trading costs and the relative rates of price discovery in stock, futures, and option markets. Journal of Futures Markets 16, 353-387. Garman, M.B., 1976. Market microstructure. Journal of Financial Economics 3, 257-275. George, T., Longstaff, F., 1993. Bid-ask spreads and trading activity in the S&P 100 index options market. Journal of Financial and Quantitative Analysis 28, 381-397. Glosten, L., Milgrom. P.R., 1985. Bid, ask, and transaction prices in a specialist market with heterogeneously informed traders. Journal of Financial Economics 13, 71-100. Glosten, L., 1987. Components of the bid-ask spread and the statistical properties of transaction prices. Journal of Finance 42, 1293-1307. Glosten, L., Harris, L., 1988. Estimating the components of the bid-ask spread. Journal of Financial Economics 21, 123-142. Ho, T., Stoll, H.R., 1981. Optimal dealer pricing under transactions and return uncertainty. Journal of Financial Economics 9, 47-73. Horst, J., Veld, C., 2003. Behavioral preferences for individual securities: The case for call warrants and call options. Working paper, University of Tilburg Huang, R., Stoll, H., 1997. The components of the bid-ask spread: A general approach. Review of Financial Studies 10, 995-1034. Jameson, M., Wilhelm, W., 1992. Market making in the options markets and the costs of discrete hedge rebalancing. Journal of Finance 47, 765-779. Jones, C., Kaul, G., Lipson, M., 1994. Transactions, volume, and volatility. Review of Financial Studies 7, 631-651. Kaul, G., Nimalendran, M., Zhang, D., 2004. Informed trading and option spreads, Working Paper University of Florida, Gainesville (FL) Kyle, A.S., 1985. Continuous auctions and insider trading. Econometrica 53, 1315-1335. Madhavan, A., Richardson, M., Roomans, M., 1997. Why do security prices change? A transaction-level analysis of NYSE stocks. Review of Financial Studies 10, 10351064. Mayhew, S., 2002. Competition, market structure, and bid-ask spreads in stock option markets. Journal of Finance 57, 931-958. Neal, R., 1987. Potential and actual competition in equity options. Journal of Finance 42, 511-531. Petersen, M., 2008. Estimating standard errors in finance panel data sets: Comparing approaches. Review of Financial Studies, Forthcoming Petersen, M., Fialkowski, D., 1994. Posted versus effective spreads: Good prices or bad quotes? Journal of Financial Economics 35, 269-292. Petrella, G., 2006. Option bid-ask spread and scalping risk: Evidence from a covered warrants market. Journal of Futures Markets 26, 843-867. Stoll, H.R., 1978. The supply of dealer services in securities markets. Journal of Finance 33, 1133-1151. Vijh, A., 1990. Liquidity of the CBOE Equity Options. Journal of Finance 45, 1157-1179. Whalley, E., 2008. Reservation bid and ask prices for options and covered warrants: portfolio effects, Working Paper Warwick Business School

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Table 1 Sample descriptive statistics

This table reports a breakdown of the covered warrants included in the sample by type and year of introduction. Frequency % 1995 1996 1997 1998 1999 2000 2001 2002 2003 % by row % by column Call 4 0.12 0.17 100.00 0 0.00 0.00 0.00 4 0.12 14 0.43 0.61 87.50 2 0.06 0.21 12.50 16 0.49 107 3.28 4.65 84.25 20 0.61 2.08 15.75 127 3.89 52 1.59 2.26 68.42 24 0.74 2.49 31.58 76 2.33 155 4.75 6.74 85.16 27 0.83 2.81 14.84 182 5.58 280 8.59 12.18 86.42 44 1.35 4.57 13.58 324 9.94 548 16.80 23.84 69.54 240 7.46 24.95 30.46 788 24.16 446 13.68 19.40 69.36 197 6.04 20.48 30.64 643 19.72 215 6.59 9.35 66.77 107 3.28 11.12 33.23 322 9.87

2004

Total

478 14.66 20.79 61.36 301 9.23 31.29 38.64 779 23.89

2,299 70.50

Put

962 29.50

Total

3,261 100.00

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Table 2 Bid-ask spread descriptive statistics

This table reports descriptive statistics for the quoted percentage bid-ask spread based on daily data. The full sample consists of 432,313 observations and refers to 3,261 covered warrants. Daily values are time-weighted averages of intraday observations. The sample period spans from November 4, 1995 to December 31, 2004. Cuf-off values (the minimum and maximum values of each quartile) are reported in square brackets.

# obs. Panel A: Full sample All observations Panel B: By time-to-maturity quartiles Quartile 1 Quartile 2 Quartile 3 Quartile 4 [0-33 days] [34-64 days] [65-102 days] [103-1,954 days] 115,908 113,626 100,128 102,651 432,313

Mean

Std Dev

Min

Median

Max

22.82

42.37

0.06

5.98

589.9

47.14 18.83 11.63 10.69

61.36 35.54 23.85 20.09

0.22 0.26 0.20 0.06

11.39 6.00 4.91 5.05

589.92 217.11 198.99 196.04

Panel C: By moneyness Out-of-the-money In-the-money Panel D: By price level quartiles Quartile 1 Quartile 2 Quartile 3 Quartile 4 [0.001-0.608] [0.609-0.162] [0.162-0.359] [0.359-102.5] 112,138 106,130 105,776 108,269 68.96 10.37 5.54 4.12 61.19 14.80 6.97 5.58 1.83 1.14 1.39 0.06 44.53 6.71 4.05 3.02 589.92 198.66 199.26 199.61 270,225 162,088 33.42 5.15 50.21 9.29 0.50 0.06 9.35 3.50 257.54 589.92

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Table 3 Explanatory variables, measures and expected impact on bid-ask spread

This table lists the variables used in the regression analysis along with the measures (or proxies) employed and the expected signs.

Category Hedging costs

Variable Initial hedging costs (IHC)

Measure

Expected Sign

IHCt =

BAStS t M t crt

Rebalancing costs (RC) Substitute warrants (SW)

RCt = tS
Number of warrants the financial institution issues on the same underlying asset Daily number of trades Number of warrants issued by all financial institutions on the same underlying asset minus SO

Order processing costs Gross expected profit

Trading volume (TV) Market competition (MC)

Control variables

Moneyness (M)

St Xe M t = Xer ( TStt ) S t St

r (T t )

if if

call put

Time-to-maturity (TTM) Relative tick size (RTS)

Number of days to the expiration date

RTS t = T

Mt
T S t M t crt

Reservation spread

Percentage reservation spread (PRBAS)

PRBAS t =

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Table 4 Panel regressions (I)

This table reports estimates of random effects models using the between regression estimator. The dependent variable is the percentage bid-ask spread (PBAS). Refer to Table 3 for independent variables definition. T-statistics are reported in parenthesis and are based on standard errors clustered by warrant to control for heteroskedasticity and nonzero stock-specific autocorrelation. 5 indicates significant at 5%; 1 significant at 1%.

Model: Independent Variables: Intercept Initial hedging costs (IHC) Rebalancing costs (RC) (x 1,000) Moneyness (M) Moneyness squared (M^2) Time-to-maturity (TTM) Time-to-maturity squared (TTM^2) Trading volume (TV) Relative tick size (RTS) Substitute warrants (SW) Market competition (MC) # of obs # of groups Wald test Prob > Chi-squared R-squared within R-squared between R-squared overall

[1]

[2]

[3]

[4]

40.571 (43.3) 0.0111 (2.8) 0.161 (6.4) -0.003 (-1.5)

44.921 (45.1) 0.0101 (2.7) 0.141 (5.9) -0.061 (-0.4) 0.001 (0.4)

30.101 (27.6) 0.0081 (2.8) 0.05 (1.8) -0.036 (-0.4) 0.001 (0.4) -0.231 (-17.9) 0.0011 (5.2) -0.311 (-9.0) 228.41 (24.8)

28.921 (19.1) 0.0081 (2.8) 0.05 (1.8) -0.034 (-0.4) 0.001 (0.4) -0.231 (-17.7) 0.0011 (5.2) -0.311 (-9.0) 228.41 (24.8) 0.005 (0.1) 0.07 (0.9)

-0.241 (-18.1)

-0.341 (-20.4) 0.0011 (5.2)

396,515 3,255 126.8 0.00 0.15 0.01 0.03

396,515 3,255 1,487.6 0.00 0.18 0.01 0.07

396,515 3,255 2,412.4 0.00 0.32 0.20 0.25

396,515 3,255 2,471.0 0.00 0.32 0.20 0.24

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Table 5 Panel regressions (II)

This table reports estimates of random effects models using the between regression estimator. The dependent variable is the percentage bid-ask spread (PBAS). Refer to Table 3 for independent variables definition. T-statistics are reported in parenthesis and are based on standard errors clustered by warrant to control for heteroskedasticity and nonzero stock-specific autocorrelation. 5 indicates significant at 5%; 1 significant at 1%.

Model: Independent Variables: Intercept Initial hedging costs (IHC) Rebalancing costs (RC) (x 1,000) Moneyness (M) Moneyness squared (M^2) Time-to-maturity (TTM) Time-to-maturity squared (TTM^2) Trading volume (TV) Relative tick size (RTS) Substitute warrants (SW) Market competition (MC) Reservation spread (PRBAS) # of obs # of groups Wald test Prob > Chi-squared R-squared within R-squared between R-squared overall

[5]

[6]

[7]

[8]

28.511 (22.1) 0.0061 (2.8) 0.221 (6.0) -0.0035 (-2.0)

32.941 (24.7) 0.0061 (2.7) 0.201 (5.9) -0.058 (-0.5) 0.001 (0.4)

24.881 (21.7) 0.0061 (2.7) 0.101 (3.2) -0.038 (-0.4) 0.001 (0.4) -0.211 (-17.0) 0.0011 (5.2) -0.301 (-8.9) 199.01 (22.3)

23.241 (14.2) 0.0061 (2.8) 0.101 (3.2) -0.035 (-0.4) 0.001 (0.4) -0.211 (-16.8) 0.0011 (5.2) -0.301 (-8.9) 198.81 (22.3) -0.03 (-0.4) 0.15 (1.8)

-0.201 (-16.3)

-0.281 (-18.6) 0.0011 (5.3)

5.101 (13.2) 396,515 3,255 833.9 0.00 0.22 0.06 0.09

4.761 (12.9) 396,515 3,255 1,897.9 0.00 0.24 0.08 0.14

2.861 (9.4) 396,515 3,255 2,777.5 0.00 0.34 0.24 0.27

2.871 (9.4) 396,515 3,255 2,838.1 0.00 0.34 0.24 0.27

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