Long-term Information, Short-lived Derivative Securities1

This paper characterizes how the short-lived nature of derivative securities, such as option and futures contracts, affects trading behavior and pricing. Specifically, the paper explores strategic trade in short-lived derivative securities by agents that possess long-term information about an underlying asset. In contrast to trading equity, where an informed agent will ultimately benefit from his trades, trading short-lived securities is profitable only if the private information is impounded in the price before expiry. A consequence is that a risk neutral informed agent’s holdings of the short-lived security affects his trading behavior: Past informed trading leads to greater future informed trading. The shorter horizon in which information must be impounded for a short-lived security to pay off makes an informed agent more reluctant to trade at earlier dates. By characterizing the conditions under which liquidity traders choose to incur extra costs to roll over their short-term positions rather than trade in distant contracts, this paper provides a possible explanation for why most markets for longer-term derivative securities have little liquidity and large bid-ask spreads. The paper also shows how fixed trading costs and round lot restrictions can lead to multiple equilibria. This paper explores strategic trading by agents who have long-term information about an underlying asset but trade short-lived derivative products. To illustrate the issues involved, consider the following hypothetical example. Suppose that in 1995, an individual becomes aware that most computer databases cannot properly recognize the year 2000 (the “Y2K computer bug”). The general public has not yet become aware of the magnitude of the problem and, as such, this information has not been reflected in the stock price of a database management company, BigRed. The individual, who has limited funds, would like to trade on his “private” information. Although the information will be revealed with certainty on January 1, 2000, the company may make a public announcement prior to this date. The individual, the “informed agent”, can engage in at least two possible trading strategies. One strategy is to shortsell BigRed. An advantage of shortselling is that as long as the informed agent can maintain his position, his information will eventually be incorporated into the share price. A possible disadvantage is that a temporary rise in the share price might expose the informed agent to large losses and force him to close his position. An alternative is to purchase put options for BigRed. Put options allow the informed agent to leverage his position and limit downside risk. Unfortunately for the informed agent, his private information may not be revealed publicly by the time the option expires, and hence may not be impounded in the price, in which case the option will not pay off. Since the informed agent will have the opportunity to purchase newly-issued options with later expiration dates as time passes, the question becomes when, and how frequently, should the informed agent purchase options? This paper addresses these issues. When the informed agent purchases a derivative security, he conveys information to the market, even if the contract does not pay off, thereby adversely affecting the price of future contracts. We show that these strategic information costs are higher for derivative securities than for equity, and more generally for shorter-term contracts than longer-term contracts. This is because, in contrast to trading equity, where an informed agent will ultimately benefit from his trades, trading short-term derivative securities is only profitable if the private information is impounded in the price before expiry. Ignoring leverage concerns, this makes an informed agent more reluctant to trade immediately in short-term derivative securities than in equity. Indeed, an informed agent may not act immediately on his private information even if it is profitable in expectation to do so, preferring to defer in the hope of obtaining better prices in the future. The attendant risk with this strategy is that the information may be revealed publicly before he can exploit his information.