DP3173 | Stock Market Quality in the Prescence of a Traded Option

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We use a controlled economic experiment to examine the implications of asymmetric information for informational linkages between a stock market and a traded call option on that stock. The setting is based on the Kyle model and Back (1993). We find that an insider trades aggressively in both the stock and the option, and that this leads to important feedback effects between the two markets: price discovery in the stock market also occurs in the option market and vice versa. The time series properties of the stock price depend directly on the intrinsic value of the option: when the intrinsic value of the option is positive, informational efficiency is higher in the market for the stock, and volatility is lower. We argue that this provides new insights into how the introduction of a traded option improves the market quality of the underlying asset.