Journal of Accounting Business & Management vol. 15 no.

2 (2008) 37-54

Drivers of Option Liquidity: Evidence from India

Sanjay Sehgal* and Vijaykumar N. Abstract The financial derivatives market in India has a more recent origin compared to the stock market. In this paper we investigate the relationship between the stock market characteristics and option market liquidity using daily data for equity options and underlying stocks in the Indian context. We find that while option liquidity proxies (options contract volume in terms of numbers and rupee value) are positively related with stock price, stock liquidity and stock return volatility; it is inversely related to uncertainty in the information environment measured by company size. We also find evidence for day of the month effect for at least one year of the study. We get consistent results with both the measures of option liquidity (options contract volume in terms of numbers and rupee value) as well as for different option types (call and put options). The findings are in the conformity with those for developed markets and shall be useful for institutional investors who actively trade in the options market owing to lower transaction cost, leverage advantage and short sale restrictions on the underlying stocks. Keywords: option liquidity, stock price, stock return volatility, equity options, information environment, panel data. JEL: C10, C12, C33, G13, G14

I. INTRODUCTION Financial derivatives have become extremely popular in the developed markets of the world and witnessing large trading volumes on the global exchanges. They are used by financial institutions, fund managers, corporate treasures and other investment communities as powerful risk management tools for hedging risks in the corresponding spot market. Besides hedgers, the regular activity of speculators provides additional liquidity to these markets. During last two decades the financial derivatives market have grown tremendously, in terms of the variety of instruments and their trading volumes. According to Bank for International Settlement (BIS) report 2005, the approximate size of global OTC derivatives market stood at US $ 284288 billion at the end of December 2005. In India derivatives explosion occurred with introduction of Index futures on National Stock Exchange (NSE) in June 2000. This was followed by commencement of trading of Index options as well as Equity option in June and July of 2001. Indian
*

First author, Professor of Finance, Department of Financial Studies, University of Delhi South Campus, ESC-Pau,France. Email: sanjayfin15@yahoo.co.in Second Author, Research Fellow, University of Delhi, South Campus

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derivatives market saw the introduction Individual stock futures in November 2001, while the Interest rate futures were available for trading from March 2003. Index futures and options were introduced based on S&P CNX-50 Index, an equity market index constructed by National Stock Exchange of India. Futures and option contracts based on CNX-IT and Bank NIFTY indices were launched in August 2003 and June 2005 respectively. After introduction of financial derivative products in India, the indigenous trading system known as Badla was banned in July 2001 as it caused excess speculation. It was instead fully replaced by the internationally acceptable option trading system, which encourages the investors to hedge portfolio risks systematically. Derivatives trading have resulted in lower cost of trading for all investors. Further the analyst perceive derivatives as risk management tools as this market provide better avenue for individual and institutional investors to hedge their portfolio risks rather than using them for speculation purposes. The total turnover of derivative contracts traded at NSE during 2004-05 was around $.556.01 billion, recording an increase of 19.54 percent as compared to $.473.48 billion in 2003-04 it was an increase of 384 percent as compared to its previous year 2002-03. The number of contracts traded in the derivatives market have also increased steadily and stood at 770172 billion in 2004-05. Both the equity options and the index options trading volume stood at $37.52 billion and $27.10 billion in 2004- 05. The corresponding figure for both the instruments in the year 2003-04 was $48.27 billion and $11.74 billion. The financial derivative markets, including option contracts have been profoundly researched for the matured economies of the world [refer to Manaster and Rendleman (1982), Huberman and Halka (1999), Hasbrouck and Seppi (2000), Chordia, Roll, and Subrahmanyam (2000, 2001) and Chordia, Shivakumar and Subrahmanyam (2001)]. There is specifically a growing body of literature that deals with the relationship between stock market variables and option market liquidity [refer to Vijh (1990), Stephan and Whaley (1990), George and Long Staff (1993), Chan, Chung and Johnson (1993), Chang, Chung and Johnson (1995), Easley, Ottura, and Srinivas (1998), Chang, Chung and Fong (2002), Dennis, Mayhew and Stivers (2003)].The depth of option market helps us to gauge its efficiency and which intern has implication for option pricing. In contrast, limited research is available for India owing to the nascent nature of its derivatives market. Most of it is related to futures market covering issues such as lead lag relationship between futures and spot market interms of pricing and trading. [see Thenmonghi (2000), Bhaskkar and Sumati (2005) captures lead lag relationship between futures and underlying cash market. J.R. Verma (2002), Anurag and Sathish (2002), Gururaj and Chugh (2002), Srivastava, Yadhav, and Jain (2002),]. Schenbagaraman, P. (2003), Narayanan Rao (2003) analyse the volatility and pricing efficiency of options in India. The research base for option contracts is even thinner. These studies fail to provide any strong evidence, because of small sample size and short study periods.

The badla system is carry forward of a position, either a short sale or a long purchase. In the event of a long purchase, the investor may want to carry forward the transaction to the next settlement cycle and for doing so he has to compensate the seller who has sold with an intention of getting cash.

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The issue relating to option liquidity and its determinants has thus for almost been ignored. In this study, we attempt to fill this research gap in the Indian context. We examine the relationship between stock market characteristics and option market liquidity for equity options. We are particularly interested in knowing if our findings about these relationships differ from those for matured markets. This paper comprises of seven sections including the present one. In section-2 we provide brief review of literature on determinants of options liquidity. The model specifications and testable hypothesis are given in section-3, while the data and their sources are described in the section-4. We discuss the methodological issues and empirical results based on Mayhew, Sarin and Shastri (1999) model in section-5. In section-6, we give the results for options liquidity and draw inferences for the Indian environment. Summary and concluding remarks are given in the last section. II. REVIEW OF LITERATURE In this section, we provide brief review of literature dealing with option liquidity and its determinants. Kumar, Sarin and Shastri (1998) analyse the impact of option listings on the quality of the market for underlying securities of the American Stock Exchanges like AMEX, CBOE, NYSE, PSE, and PHLX. They tried to find out the impact of options listings on liquidity, order flow, change in liquidity, adverse selection component of Bid-Ask Spreads, and the weight placed on public information and the variance of the pricing error of the underlying securities for the above exchanges from 1983-1989. They find that option listings decrease with adverse selection component of the underlying stock's bid-ask spread and increase with liquidity, order flow, change in liquidity of the underlying stocks. The option listings are also increase with the weight placed on public information. Finally, they show that option listings are decreasing function of variance of the pricing error, which implies greater pricing efficiency and higher market quality. Mayhew, Sarin and Shastri (1999) examined the magnitude of the order flow in options related to the characteristics of the underlying stock. They consider three proxies as measure of option liquidity namely trading volume, dollar value of trades and number of option transactions. They also use stock price, stock return volatility, number of shares traded, percentage ratio of the stock's bid ask spread over market depth, firm size and number analysts as explanatory variables. They use one year data for characteristics information of 254 underlying stock of American Stock Exchange (AMEX) and corresponding options listed with Chicago Board of Options Exchange (CBOE). The study finds that high priced, highly volatile and larger trading volume components of the underlying stocks tend to have positive influence on options liquidity, whereas an increasing spread-to-death ratio of the stocks reduces the liquidity on the options market. Chordia, Roll and Subrahmanyam (2000) measure the commonality in time series movements of liquidity attributes of a single asset. They document that individual stock liquidity related to market and industry liquidity. The later co-move with quoted spreads, quoted depth, and effective spreads. The market and industry liquidity co-move with quoted spreads, quoted depth, and effective spreads after holding constant the impact of well known determinants of stock liquidity such as volatility, volume, and price. After analysing commonality in liquidity Chordia, Roll and Subrahmanyam (2001) study how the aggregate market liquidity behaves over

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time. They find that stock liquidity measured by spread and depth fall significantly in down market but increase weakly in upmarkets and the higher market-wide volatility decrease over trading activity and spread of the subsequent periods. They also explore strong day-of-the week effect where Fridays exhibit the lowest and Tuesdays the highest liquidity. Kalodera and Schlag (2003) investigate the relationship between option market liquidity and underlying stock market activity for the firms included on the German DAX index and the options traded on the EUREX (electronic exchange). They classify liquidity measures as transaction based (volumes and trading frequency) and order based (spreads and depth) and perform panel data regression including dummy variables for the day of week. They split the sample into buyer and seller initiated trades and show that on days with positive stock returns the number of call purchases increase whereas on days with negative returns they decrease. Call sales increase during both downward and upward stock movements. A similar effect was also observed for put options. They also find that stock volume impact on transactionbased liquidity increase with option market trading activity. Chordia, Roll and Subrahmanyam (2005) measure the liquidity and efficiency of the financial market documenting capacity of the equity markets to absorb imbalances that vary through time and across different liquidity regime. They find that liquidity facilitates determination of efficiency, i.e., when the market is highly liquid, it has the capacity to accommodate larger order flow. They also explore that order imbalances predict future returns for small firms on short interval and the market absorb order imbalance greatly in liquid period than in illiquid period. Goyenko. R (2005) examines the liquidity linkage between stock and bond markets and determinants of liquidity over the period of July, 1962 through December, 2003. They compute Bond liquidity from quoted spreads for the same time period across bonds of all maturities, callable and noncallable, certificates of indebtedness, tax anticipation bills and other treasury debt instruments (first and last months of trading are deleted). They find a significant causal relationship between the liquidity of the two asset classes. The vector autoregression analysis shows that returns, volatility, and momentum profits are important drivers of liquidity. Monetary policy variables have a stronger effect on bond liquidity than on stock liquidity. III. MODEL SPECIFICATION AND TESTABLE HYPOTHESIS

Mayhew, Sarin and Shastri (1999) proposed the following model to test the relationship between stock market characteristics and option market liquidity. Yi = + 1 SPi + 2 SRVi + 3 TVi + 4UNIEi + ei Where, Yi is a measure of option liquidity SPi is stock price of the asset i SRVi is stock return volatility of asset i TVi is trading volume of asset i UNIEi is the uncertainty in information environment of the firm. ei is error term (1)

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This model involves use of four stock market characteristics that are expected to explain the option liquidity. Manaster and Rendleman (1982) argue that options are superior investment vehicle as compared to the underlying stock owing to their inherent leverage, lower transactions cost, and their ability to avoid short sale restrictions on the underlying stocks. Thus, higher transaction cost in the underlying stock and greater leverage in trading of options compared to the stock shall imply higher option liquidity. This suggests that option liquidity should be an increasing function of the price level of the underlying security. This hypothesized positive relation is a consequence of the fact that the cost of transacting in a particular stock is an increasing function of the price level of the stock. This is further reinforced by the fact that the leverage advantage of trading in options vis--vis the underlying common stock should also be an increasing function of the stock price. A second expected relationship between option liquidity and the characteristics of the underlying stock is that options allow an investor in the stock to hedge their stockholdings. Since the objective of hedging is to reduce the return volatility of ones holding, it implies that the liquidity of a hedging instrument should be an increasing function of the level of volatility of the underlying stock. The third, stock characteristic that impacts option liquidity is the trading volume of the underlying stock. The relationship is implied by the fact that interest in an option is driven by the interest in the underlying stock. On the other hand, option liquidity will be negatively related to activity (measured by trading volume) in the underlying stock provided investor treat option as competing asset with the stock. Finally, it has been suggested that option markets serve as an outlet for informed trading and improve the efficiency of the underlying market by increasing the level of public information in the market [see Amin and Lee (1994), Easley, OHara and Srinivas (1994), John, Koticha and Subrahmanyam (1994) and Kumar, Sarin and Shastri (1998)]. This argument implies that benefits from option trading should be higher for stocks of firms that are in a more uncertain information environment. Specifically, this would suggest that options would be more liquid the larger the potential gain from trading on private information. In addition, this argument also implies that the information asymmetry component of the spread should be smaller for stocks with more liquid options. Thus, if option markets serve as an outlet for informed trading, one could argue that the probability of an informed trade in the stock market is lower for stocks with more liquid options. This, in turn, implies that the expected loss from informed trading is lower for stocks with more liquid options, hence resulting in a lower information asymmetry component of spread for these stocks. We use market capitalisation as a proxy for the uncertainty in the information environment of the underlying stock. Since we would expect the uncertainty in the information environment to be a decreasing function of the size of the firm, option liquidity should also be a decreasing function of stocks market capitalisation. Goyenko. R (2005) find a significant causal relationship between the liquidity of the two asset classes viz bonds and equities. Our study concentrate on equity options and owing to the fact that Mayhew, Sarin and Shastri (1999) find strong results in similar analysis for US market. Therefore, we adopt the Mayhew, Sarin and Shastri model for the Indian environment with small modification. We introduce a dummy variable to capture the day of month effect. It may be noted that option trades are settled in India on the last Thursday of every month, and hence this impact should be

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incorporated in our estimation process. The dummy variable shall take a value equal to one on settlement day and equal to zero for all other trading days. IV. DATA The data comprises of daily option contracts in numbers and in currency unit (rupees) for both call and put options for the calendar years 2004 and 2005. The option contracts in numbers and rupee terms are used as option liquidity proxies in our study. The data is collected for 38 out of 51 companies for which option contracts were available at the beginning of 2003. The sample size has been restricted to avoid companies that are infrequently traded and hence may introduce a thinness of trading bias in our results. We select only those companies that traded for more than 75 percent of the total trading days for each calendar year. The sample size is approximately 75 percent of the total companies on which option contracts were available for the study period, and should be representative of equity options market in India. The data source for option contract is Futures and Options (F&O) Segment of National Stock Exchange (NSE) website. We also collect daily stock price data for the sample companies for the matching period. The share prices are adjusted for capitalisation changes such as stock dividends, stock splits, stock buybacks, and rights issues. The stock price data is used to estimate stock returns and stock volatility, as we shall see in the next section. We also obtain daily trading volume information for the sample companies which shall act as measure of stock liquidity. The data source is equity market segment on the NSE website. We also obtain daily market capitalisation values (price times number of shares outstanding) for our sample set where market capitalisation is used as a firm size proxy. The data source is CMIE-Prowess a database of Centre for Monitoring Indian Economy (CMIE). V. ESTIMATION PROCEDURE Mayhew, Sarin, and Shastri (1999) estimate the model specified in equation (1) using cross-sectional regression methodology with average of the coefficients across time, so that any time-series variation in trading activity is smoothed out. However, they do not make any distinction between calls and puts, which implicitly introduces the assumption that the two types of options behave more or less identically. We distinguish between different types of options and run separate regression with daily data, since the coefficients in the regression equations should differ systematically between calls and puts. We analyze the largest and most frequently traded companies in the Indian options market. We are not interested how each stocks character influences the option liquidity, but in general option market as whole. Still, simply pooling the data without considering any individual effects among firms would bias the results, especially as the daily trading level of the firms (such as total daily volume and number of daily transactions) substantially differs in both the stock and the options market. In order to capture the possible heterogeneity at the levels of dependent and independent variables we group the firms into three categories according to their number of average daily option trading volume in terms of number of contracts and currency value.

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We use two measures of options liquidity i.e. options contract volume in numbers (Y1) and options contract volume in rupees (Y2). Where, Y1 and Y2 are summation of daily-log value of options volume in numbers and in rupees respectively for the near month to expiry of the options. Summation process involves adding of daily options volume (for Y1 and Y2 separately) for all exercise price on a given day. We exclude middle of the month and far away month from our analysis as option liquidity data negligible for them except when only a few days are left for the expiration of the near month contract. The independent variables i.e. underlying stock characteristic variables are the stock price (SP), stock return volatility (SRV), stock trading volume (TV), a measure of information uncertainty (UNIE) and dummy (D) variable for settlement day effect. The SP is daily-log closing stock prices of the individual firms; SRV is the standard deviation of daily continuously compounded rate of return for the underlying stocks returns between day t and proceeding 14 trading days. The TV is measured as log of daily trading volume of the underlying stock and the log of daily stocks market capitalisation which is used as measure of uncertainty in information environment along with stock return volatility (SRV), as mentioned in the previous section. This study covers two calendar years i.e. 2004 and 2005. We estimate our regressions separately for two calendar years as well as for the call, put, and aggregate (call + put) data. The sample contains 38 firms and three liquidity groups low, medium and high comprised of 13, 12, and13 respectively. We employ the panel data analysis to capture the dynamic behaviour of the parameters and to provide the more efficient estimation and information of the parameters. Our data set is unbalanced because there is some missing information for daily option liquidity (our dependent variable) for some of the firms. The traditional panel data model includes three different methods: a) common constant method, b) fixed effects method, and c) random effects method. In our study, we incorporate all these methods to analyse the robustness of parameter coefficients in explaining the relationship between options liquidity and underlying stocks. We reject the fixed effects method in our analysis based on the Hausman specification test (1978) [a test which assists in making choice between the fixed effects and random effect methods]. We concentrate on Common constant method and Random effects method which is more sophisticated than former. We are using Common constant along with random effects because our data classification is a priori homogeneous. We ensure homogeneity by classifying our sample companies on option liquidity criterion, and estimate separate regression for each liquidity group. In some, our estimation differs from Mayhew, Sarin and Shastri (1999) in four ways: a. Introduction of a dummy variable to capture day of month effect in the Indian context. b. Use of high frequency data i.e. daily data instead of annual data employed by them. c. Use of panel data regression which is more acceptable tool of estimation using viz- a- viz conventional cross sectional regression. And d. Separate model estimation for call, put and aggregate data. While their estimation process deals with only aggregate data.

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VI.

EMPIRICAL RESULTS

The table 1 and 2 provide the results based on Common constant method for measure of options liquidity [option contract volume in number (Y1) and option contract volume in rupee (Y2)]. Table 3 and 4 provide similar results for random effects method. Each of these tables has two panels: panel A and B that deal with the results for the calendar years 2004 and 2005 respectively. Each panel intern has three matrices namely call options, put options and aggregate of call and put options. Referring to table 1 and 2 the co-efficient of stock price become strongly positive (as shown by the corresponding t statistics) as we move from low liquidity to high liquidity group for both calls as well as put option. This seems to confirm our hypothesis that stock prices that tend to proxy for the level of transaction cost and the leverage advantage of options are generally positively related with option liquidity. Table 1 The relationship between stock characteristics and equity options liquidity (measured in terms of options contract volume in numbers): Empirical results based on Common constant method. Panel- A- Calendar year 2004

Call options
Low Coef. SP SRV TV MKC D 0.17377 -0.00181 0.351527 -0.01772 0.056625 t 6.74* -9.58 11.68* -0.49 1.14 Option liquidity group Medium Coef. 0.065159 -0.00116 0.799392 -0.03519 0.018111 0.4738 t 6.71* -9.49 48.16* -1.52 0.67 Coef. 0.185578 -7.1E-05 0.705811 0.06946 0.063708 0.6105 High t 21.63* -2.85 55.96* 4.75 3.14*

Adj R2 0.0781 *Significant at 5 percent level

Put options
Low Coef. SP SRV TV MKC D -0.0166 0.000122 0.076878 -0.09948 0.02399 t -0.92 0.85 2.39* -2.66* 0.45 Option liquidity group Medium Coef. 0.060374 -0.00315 0.427509 0.215826 -0.03851 0.1403 t 3.46* -6.3 18.23* 5.73 -0.91 Coef. 0.398984 -6.3E-05 0.915106 -0.16988 0.039993 0.5602 High t 31.89* -1.76 53.18* -8.28* 1.38

Adj R2 0.013 *Significant at 5 percent level

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Aggregate data
Low Coef. SP SRV TV MKC 0.149548 -0.00067 0.321207 -0.05138 t 6.98* -5.22 11.79* -1.63 Option liquidity group Medium Coef. 0.141761 -0.0037 0.639519 -0.18065 0.02683 0.4028 t 13.62* -6.85 42.42* -8.75* 1.05 Coef. 0.225431 -6.4E-05 0.736744 0.018161 High t 26.27* -2.57 58.41* 1.24

D 0.012629 0.29 Adj R2 0.056 *Significant at 5 percent level

0.070354 3.47* 0.6276

In this table the independent variable SP denotes Stock price, SRV denote Stock return volatility, TV denote Stock trading volume, MKC denote Stocks market capitalisation and D denote day of the month effect. The symbols discussed carry the same meaning in the remaining tables.

Panel-B- Calendar year 2005

Call options
Low Coef. SP -0.06541 SRV 0.000186 TV 0.738169 MKC -0.05938 D -0.06922 2 Adj R 0.2687 *Significant at 5 percent level t -3.15 1.21 24.62* -1.86* -1.49 Option liquidity group Medium Coef. -0.0297 -0.00022 0.739564 0.056919 -0.03369 0.4201 t -2.56 -2.76 41.02* 2.38 -1.1 Coef. 0.147375 0.000926 0.942578 -0.01664 -0.01479 0.6524 High t 12.59* 3.89* 66.95* -0.93 -0.65

Put options
Low Coef. SP SRV TV MKC D 0.128044 -0.00043 0.25989 0.035 -0.03858 t 5.18* -1.13 7.39* 0.86 -0.74 Option liquidity group Medium Coef. -0.05441 -0.00019 0.50967 0.140419 -0.04079 0.1322 t -3.04 -1.57 17.49* 3.71 -0.84 Coef. 0.36099 0.000494 1.158606 -0.25889 -0.03395 0.5442 High t 19.22* 3.72* 52.41* -8.26* -0.91

Adj R2 0.0316 *Significant at 5 percent level

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Aggregate data
Low Coef. SP SRV TV MKC D -0.02392 -0.00099 0.747229 -0.08071 -0.06897 t -1.31 -4.01 28.51* -2.78* -1.64 Option liquidity group Medium Coef. -9.4E-05 5.38E-05 0.690052 0.070747 -0.04103 0.4132 t -0.01 0.78 36.77* 2.96 -1.28 Coef. 0.197676 0.000702 0.982529 -0.07219 -0.01619 0.6624 High t 16.46* 2.87* 68.0* -3.92* -0.70

Adj R2 0.2669 *Significant at 5 percent level

Table 2 The relationship between stock characteristics and equity options liquidity (measured in terms of options contract volume in rupees): Empirical results based on Common constant method. Panel- A- Calendar year 2004

Call options
Low Coef. SP SRV TV MKC D 0.2114 -0.00186 0.434704 -0.00577 0.04341 t 8.22* -9.88 14.48* -0.16 0.87 Option liquidity group Medium Coef. 0.042103 -0.0013 0.841392 0.205891 -0.01159 0.4477 t 3.51* -9.91 47* 7.77 -0.4 Coef. 0.253973 -7.4E-05 0.878986 0.019776 0.065707 0.5693 High t 21.64* -2.35 52.48* 1.07 2.56*

Adj R2 0.106 *Significant at 5 percent level

Put options
Low Coef. SP SRV TV MKC D -0.00049 8.39E-05 0.199792 -0.08468 -0.03447 t -0.03 0.55 6.45* -2.49* -0.62 Option liquidity group Medium Coef. 0.169221 -0.00297 0.505789 0.028464 -0.0061 0.1461 t 6.83* -6 19.28* 0.5 -0.14 Coef. 0.370725 -2.7E-05 1.015467 -0.11851 0.069076 0.5082 High t 25.98* -0.63 49.92* -5.2* 2.02*

Adj R2 0.0275 *Significant at 5 percent level

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Aggregate data
Low Coef. SP SRV TV MKC D 0.106167 -0.00072 0.353649 0.057042 0.017809 t 5.44* -5.52 13.08* 1.9 0.41 Option liquidity group Medium Coef. 0.064424 -0.0023 0.675994 0.094436 0.027195 0.3744 t 4.84* -4.88 40.28* 3.58 0.95 Coef. 0.278727 -6.3E-05 0.896743 -0.00897 0.06661 0.5718 High t 23.5* -1.96 52.98* -0.48 2.57*

Adj R2 0.0794 *Significant at 5 percent level

Panel- B- Calendar year 2005

Call options
Low Coef. SP SRV TV MKC D 0.005237 0.000153 0.809374 -0.13629 -0.11459 t 0.26 1.02 27.68* -4.38* -2.54* Option liquidity group Medium Coef. -0.03577 -0.00029 0.813262 0.108377 -0.04625 0.442 t -2.93 -3.49 42.89* 4.31 -1.43 Coef. 0.222853 -0.00014 1.063864 -0.07511 -0.03907 0.7033 High t 18.98* -0.57 75.31* -4.17* -1.72

Adj R2 0.2833 *Significant at 5 percent level

Put options
Low Coef. SP SRV TV MKC D 0.164651 -0.00045 0.287298 -0.05573 -0.07946 t 7.09* -1.63 8.24* -1.36 -1.53 Option liquidity group Medium Coef. -0.01317 -0.00011 0.605862 0.156802 -0.03098 0.1586 t -0.68 -0.84 20.47* 4.05 -0.63 Coef. 0.413425 0.000235 1.28291 -0.32091 -0.05543 0.5821 High t 21.76* 1.75* 57.34* -10.12* -1.47

Adj R2 0.0378 *Significant at 5 percent level

Aggregate data
Low SP SRV TV MKC D Coef. 0.100327 -0.00105 0.835995 -0.14322 -0.10701 t 5.57* -4.62 34.45* -5.35* -2.75* Option liquidity group Medium Coef. 0.024643 -3E-05 0.772849 0.071835 -0.05039 0.4459 t 2.09* -0.42 41.22* 2.96 -1.56 Coef. 0.278683 -0.00046 1.094234 -0.13139 -0.05439 0.7091 High t 23.12* -1.88 75.45* -7.11* -2.33*

Adj R2 0.3123 *Significant at 5 percent level

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Examining the relationship between the volatility of the underlying stock and the stock option liquidity, we find conflicting results for the years 2004 and 2005. Such a relationship is statistically significantly negative for the first calendar year implying that investors do not treat stock options as a hedging instrument to mitigate risk arising from higher volatility. The relationship seems to reverse in 2005 and conforms to our hypothesis as the t statistics for volatility coefficients claim as we move from low to high liquidity group and become statistically significantly positive. These results probably point out that Indian financial derivatives market is maturing over time with hedgers playing a more dominant role compared to speculators, who try to take larger position in the underlying stock with increased volatility and ignore the equity options in the trading process. This can be shown by the fact that institutional investors (who generally have hedging objectives) account for a much larger portion of trading volume in 2005 vis--vis 2004 compared to small investors who generally exhibit speculative behaviour. Further the results for 2005 are more reliable as the trading volumes in the year are twice as lager to the previous year indicating the improved depth of the market. We find the relationship between stock trading volume and option market liquidity to be strongly positive as the t coefficients for high liquidity groups are substantially higher than those for low liquidity groups. This implies that options are not being treated as alternative assets in the Indian scenario and instead, the interest in options is driven by the underlying stock. Next, we examine the relationship between company size (market capitalisation of the underlying stocks) and option liquidity. While such a relationship is not clear for call options; the put option results are as predictable. It seems that investors become more active on put options for relatively smaller firms where size acts as a measure of information uncertainty and varies inversely with it. Finally, we find that the day of the month does not seem to have any significant effect on option liquidity as it reflected by the coefficient of the dummy variable introduced in our model in case we use option contract volume in number as measure of option liquidity. However, we observe that day of the month effect positively influences option liquidity when the latter is measured in terms of option contract volume in rupee. Thus our empirical results are generally robust to the choice of option liquidity proxy except for the settlement day phenomenon. Our results based on Random effects method (as shown in table 3 and 4) are very similar to those for the Common constant method. We avoid interpreting the R2 as a goodness of fit, which is the case in panel data estimation. However, the F test supports the superiority of the Common constant method at 5 percent level over the random effects method in our analysis. This may be owing to the fact that we a priori classified sample on the basis of option liquidity and run separate regression for different groups, thus ensuring minimum variation with in the group. Our empirical results on determinants of option liquidity are quite similar to those for the matured markets (see Mayhew, Sarin and Shastri 1999) while option liquidity, in general, is positively related with stock prices, stock return volatility and stock trading volume; it exits an inverse relationship with company size. Moreover, the day of the month effect seem to be positively affecting option liquidity (measured in terms of option contract volume in rupee). Our results are robust to alternative measure of option liquidity. The liquidity behaviour of call and put options is almost identical with exception of the uncertainty in the information environment argument which we attempt to capture by using a size proxy as it holds well only for the latter

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type of option. This asymmetry in our results for different option types needs to be further examined. Table 3 The relationship between stock characteristics and equity options liquidity (measured in terms of options contract volume in numbers): Empirical results based on Random effects method. Panel- A- Calendar year 2004

Call options
Low Coef. SP SRV TV MKC D R2 0.235907 -0.00163 0.256556 1.394126 0.078741 z 5.28* -8.89 7.52* 9.45 1.69 Option liquidity group Medium Coef. 0.206552 -0.00097 0.76369 0.089198 0.024217 0.2785 z 7.06* -8.04 42.5* 1.16 0.94 Coef. 0.210183 -7.5E-05 0.666766 0.323662 0.068344 0.5523 High z 10.01* -3.12 40.9* 6.23 3.63*

OVA 0.0192 *Significant at 5 percent level

Put options
Low Coef. SP SRV TV MKC 0.018642 -0.00012 0.151339 0.013933 z 0.48 -0.79 3.75* 0.14 Option liquidity group Medium Coef. 0.189898 -0.00272 0.421162 0.36245 z 2.54* -4.99 14.52* 1.96 Coef. 0.224039 -2.8E-05 0.758772 0.580206 High z 8.21* -0.92 39.44* 7.33

D 0.015665 0.3 OVA R2 0.0013 *Significant at 5 percent level

-0.03674 -0.91 0.0852

0.056354 2.43* 0.4211

Aggregate data
Low Coef. SP SRV TV MKC D 0.277361 -0.00054 0.248994 0.939873 0.029862 z 8.07* -4.33 7.99* 7.24 0.73 Option liquidity group Medium Coef. 0.328247 -0.00425 0.679046 -0.01008 0.033534 0.2634 z 7.44* -8.43 42.06* -0.1 1.45 Coef. 0.209412 -5.9E-05 0.670015 0.411875 0.07805 0.5399 High z 10.05* -2.53 42.56* 7.41 4.32*

OVA R2 0.0136 *Significant at 5 percent level

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Panel- B- Calendar year 2005

Call options
Low Coef. SP SRV TV MKC -0.13672 -0.0002 0.665774 -0.36631 z -4.02 -1.32 20.51* -3.16* Option liquidity group Medium Coef. 0.008023 -0.00023 0.891192 -0.21126 z 0.54 -2.99 46.77* -3.22* Coef. -0.00597 0.000438 0.858822 -0.05712 High z -0.07 1.94* 54.57* -0.34

D -0.05655 -1.32 OVA R2 0.2364 *Significant at 5 percent level

-0.07033 -2.48* 0.3944

0.000352 0.02 0.5252

Put options
Low Coef. SP SRV TV MKC -0.18506 -0.0005 0.355568 -0.57432 z -2.48 -1.35 9.88* -3.28* Option liquidity group Medium Coef. -0.0583 -0.00038 0.657774 -0.01323 z -2.03 -3.01 21.63* -0.1 Coef. 0.002551 0.000121 0.9185 -0.10002 High z 0.08 0.94 33.72* -0.93

D -0.06978 -1.49 OVA R2 0.0014 *Significant at 5 percent level

-0.07843 -1.77 0.1238

0.008686 0.27 0.4053

Aggregate data
Low Coef. SP SRV TV MKC D -0.19096 -0.00154 0.652664 -0.93187 -0.05176 z -4.16 -6.94 23.83* -7.24* -1.41 Option liquidity group Medium Coef. 0.011094 -7.61E-6 0.804504 -0.12492 -0.06517 0.3939 z 0.75 -0.11 39.39* -1.75* -2.15* Coef. 0.023748 0.000544 0.862598 -0.11018 0.006113 0.5281 High z 0.28 2.37* 53.98* -0.64 0.31

OVA R2 0.1212 *Significant at 5 percent level

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Table 4 The relationship between stock characteristics and equity options liquidity (measured in terms of options contract volume in rupees): Empirical results based on Random effects method. Panel- A- Calendar year 2004

Call options
Low Coef. SP SRV TV MKC D 0.329587 -0.00165 0.322167 1.065061 0.067193 z 7.82* -8.8 9.36* 9.12 1.42 Option liquidity group Medium Coef. 0.265752 -0.00094 0.798777 0.844927 -0.00137 0.0993 z 7.97* -7.69 43.09* 9.36 -0.05 Coef. 0.361789 -6.4E-05 0.793117 1.18692 0.077484 0.3472 High z 15.84* -2.54 47.3* 18.23 4.01*

OVA R2 0.0357 *Significant at 5 percent level

Put options
Low Coef. SP SRV TV MKC 0.023973 -0.00023 0.211083 0.193148 z 0.57 -1.44 5.18* 1.88 Option liquidity group Medium Coef. 0.185351 -0.00196 0.489482 0.953206 0.001807 0.058 z 2.15* -3.82 16.23* 4.2 0.04 Coef. 0.342519 -1.9E-05 0.846861 1.272612 High z 11.89* -0.61 42.32* 14.89

D -0.03025 -0.56 OVA R2 0.0016 *Significant at 5 percent level

0.087539 3.61* 0.2771

Aggregate data
Low Coef. SP SRV TV MKC D 0.303225 -0.0006 0.320107 0.919902 0.024761 z 9.22* -4.79 10.24* 8.99 0.61 Option liquidity group Medium Coef. 0.328574 -0.00266 0.733929 0.414199 0.028849 0.1529 z 6.13* -6.14 42.34* 3.4 1.16 Coef. 0.353933 -4.8E-05 0.787867 1.276961 0.080848 0.3404 High z 16.09* -2.01 48.96* 19.94 4.37*

OVA R2 0.0282 *Significant at 5 percent level

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Panel- B- Calendar year 2005

Call options
Low Coef. SP SRV TV MKC D -0.06397 -9.4E-05 0.682025 -0.07123 -0.08622 z -1.97 -0.61 21.3* -0.76 -2.02* Option liquidity group Medium Coef. 0.074714 -0.00023 1.009964 -0.25424 -0.09232 0.4101 z 4.9* -3.02 52.12* -3.1* -3.22* Coef. 0.430431 0.000204 0.933629 -0.38882 -0.01222 0.6481 High z 5.24* 0.9 58.97* -2.31* -0.64

OVA R2 0.2798 *Significant at 5 percent level

Put options
Low Coef. SP SRV TV MKC -0.1985 -0.00088 0.338576 -0.16546 z -3.24 -3.25 9.32* -1.03 Option liquidity group Medium Coef. 0.031204 -0.00023 0.766643 0.076376 z 1.03 -1.65 24.22* 0.58 Coef. 0.102604 0.000124 1.010876 0.159922 -0.00527 0.546 High z 3.36* 0.97 37.22* 1.45 -0.16

D -0.09838 -2.05* OVA R2 0.0002 *Significant at 5 percent level

-0.06785 -1.48 0.1577

Aggregate data
Low Coef. SP SRV TV MKC D R2 -0.05248 -0.00139 0.67501 -0.48781 -0.06788 z -1.24 -6.4 24.96* -4.44* -1.86 Option liquidity group Medium Coef. 0.079429 3.90E-07 0.916981 -0.12795 -0.08114 0.4346 z 5.33* 0.01 44.73* -1.81* -2.69* Coef. 0.473536 0.000178 0.923503 -0.45738 -0.01952 0.6509 High z 5.54* 0.78 57.73* -2.6* -1.0

OVA 0.2293 *Significant at 5 percent level

VII. SUMMARY AND CONCLUSION India has an organised capital market for more than 100 years. However, its equity derivatives market is very nascent in origin and therefore relatively less researched upon. In this paper we attempt to identify determinants of equity option liquidity using a sample of 38 firms for the years 2004- 2005. We find that option liquidity is positively related with underlying stock price, trading volume as well as return volatility (for part of the study period). Further, option liquidity is negatively related to the uncertainty in the information environment, which we measure by using company size as a surrogate. There also seems to be a day of the month effect for at

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least one of the years. Our results are robust in general for different measures of option liquidity and different option types. Our findings are in conformity with those for mature capital markets. Thus implying that stock characteristics universally impact option market liquidity provided, the given market has achieved a critical maturity level reflected by range of instruments, range of securities on which options are available, the trading volume thereon. Our results shall be interesting for institutional investors who are attracted to trade in derivatives market owing to lower trading costs, leverage benefit of the options and restriction on short selling in the underlying stocks. Prediction of option liquidity is pertinent in light of the fact that it affects the price discovery mechanism and has bearing on the level of efficiency of the given market. REFERENCES Amin, K. J. and C. Lee, 1994, Option trading and earning news dissemination, Working paper, University of Michigan. Anurag and Sathish, 2002, Implied volatility and options market efficiency, www.fineprint.com Baltagi, B.H., 2001, Econometric Analysis of Panel Data. (John Wiley and Sons Chichester) xx edn. Baskar and Sumati, 2005, Lead-lag relationship in Indian stock market: Empirical evidence, Ninth Capital Markets conference, Indian Institute of Capital markets. Beber.A, Determinants of the implied volatility function on the Italian Stock Market, Working paper. Chan, K., P. Chung, and W. Fong, 2002, The Informational Role of Stock and Option Volume, Review of Financial Studies 15, 10491075. Chan, K., P. Chung, and H. Johnson, 1993, Why Option Prices Lag Stock Prices: A Trading-Based Explanation, Journal of Finance 48, 19571967. Chan, K., P. Chung, and H. Johnson, 1995, The Intraday Behavior of Bid-Ask Spreads for NYSE Stocks and CBOE Options, Journal of Financial and Quantitative Analysis 30, 329346. Chordia, T., R. Roll, and A. Subrahmanyam, 2000, Commonality in Liquidity, Journal of Financial Economics 56, 328. Chordia, T., R. Roll, and A. Subrahmanyam, 2001, Market Liquidity and Trading Activity, Journal of Finance 56, 501530. Chordia, T., L. Shivakumar, and A. Subrahmanyam, 2001, The Cross-Section of Daily Variation in Liquidity, Working Paper. Chordia, T., R. Roll, and A. Subrahmanyam, 2005, Liquidity and Market Efficiency, Working Paper. Dennis, Mayhew and Stivers ,2003, Co-movements in the Option and Spot Markets: Contrasting Equity-Index versus Firm-Level Behavior, Working paper. Easley, D., M. OHara, and P. Srinivas, 1998, Option Volume and Stock Prices: Evidence on Where Informed Traders Trade, Journal of Finance 53, 431 465. George, T.J., and F.A. Longstaff, 1993, Bid-Ask Spreads and Trading Activities in the S&P 100 Index Options Market, Journal of Financial and Quantitative Analysis 28, 381397.

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