Capital Structure, Derivatives and Equity Market Quality
Ekkehart Boehmer, EDHEC Business School
Sudheer Chava, Georgia Tech University
Heather E. Tookes, Yale University

We examine how the existence of a market for individual equity options, publicly traded corporate bonds or credit default swap (CDS) contracts affects equity market quality for a panel of NYSE listed firms during 2003-2007. We find that firms with listed equity options have more liquid equity and more efficient stock prices. By contrast, firms with traded CDS contracts have less liquid equity and less efficient stock prices, especially when equity markets are in a “good” state (i.e., when there are more liquidity traders, less disagreement and the firm is further away from default). The impact of having a publicly traded bond is more mixed, but is generally negative. Trading activity in related markets, rather than their existence, plays a strong negative role for liquidity but not for price efficiency. Our findings are robust cross-sectionally, in the time series, and after implementing a matched-sample methodology. Taken together, our results imply an overall negative effect of related markets when those markets are tied to debt in a firm’s capital structure.

When the risks inherent in equities trade in different forms in various markets, liquidity in the equity market may be enhanced or impaired. Market quality may improve if the additional markets generate more demand for trading in the underlying securities or if they improve price formation. Market quality may suffer if the other markets siphon trading interest from the underlying equity markets. This study examines the effect of related markets on the liquidity in the equity markets. The results are important to regulators who may want to control the proliferation of trading venues. They also are important to equity investors who need to determine whether sufficient liquidity is available for their trading strategies.