Equity derivatives [electronic resource] : regulation and uncertainty
Keywords: Economics

The synthesizing element of this dissertation is the use of financial data to research topics relevant for the regulation of financial markets and for policy aimed at stimulating economic activity. The first chapter, entitled "The Effect of Uncertainty on Investment: Evidence from Options" and co-authored with Luke Stein, uses information incorporated in securities prices to understand firm behavior. In particular, the research presents new empirical evidence on the relationship between uncertainty and firm-level investment. The chapter's contributions fall into two categories: measurement and identification. We use the expected volatility of stock prices as implied by equity options as a proxy for the uncertainty faced by firms. In addition, we introduce a natural instrument strategy that relies upon variation in firms' exposure to the volatility of energy prices and currency exchange rates. We find a negative and statistically significant relationship between uncertainty and investment that is robust across a variety of specifications. The coefficient estimates are larger in magnitude after addressing the endogeneity of the uncertainty measure, suggesting potential reverse causation that biases the OLS estimates towards zero. The second and third chapters use financial data to analyze topics capturing regulatory attention in equity markets. The second chapter evaluates the Securities Exchange Commission's implementation of a "penny pricing" pilot in the exchange-traded equity options market in February 2007. The initial phase of this trial required options exchanges to reduce the minimum bid-offer spread from five or ten cents to a penny for the options corresponding to thirteen underlying equity securities. The chapter presents an analysis of the market impact of the Penny Pilot and highlights the SEC's central role in shaping the options market's innovations and competitive environment. Beyond a reduction in bid-offer spreads, the pilot has stimulated a variety of changes in trading dynamics and market structure. These repercussions include thinner markets, changes in market maker fee structures, the introduction of alternative trading venues, and incentives for the exchanges to prioritize further technological innovation. The third chapter, entitled "Fails to Deliver: The Price Impact of Naked Short Sales", presents research on the effect of naked short selling on asset prices and trading dynamics. The chapter evaluates the validity of the claim that naked shorting leads to negative excess returns by creating additional selling pressure. While data on naked short sales is not available, Securities Exchange Commission data on failures to deliver is a strong proxy. Fail to deliver data for 2004 covers a period during which the prevalence of naked short selling was not public knowledge since neither the fail to deliver data nor the Regulation SHO Threshold List was publicly available. In excluding information and regulation effects, the analysis isolates potential microstructure price effects. Using a methodology that constructs daily portfolios according to the quantity of naked short selling, I find no evidence that stocks subject to naked short selling experience negative excess returns. Rather, I find evidence that these stocks outperform on the day the trades occur. Naked short sellers appear to target stocks that outperform during the trading day and cover existing fails on days when the stocks underperform. This outperformance is not evident for stocks subject to the greatest amount of naked short selling, suggesting that positive excess returns may be offset by the additional selling pressure.