Leverage, Derivatives, and Asset Markets

Abstract

This dissertation consists of three independent essays on the relationship between leverage, derivatives (especially, option securities), and asset markets. Chapter 1, "Does the Tail Wag the Dog? How Options Affect Stock Price Dynamics," demonstrates empirically that the existence and trading of financial options affects the price movements of their underlying assets, due to the implicit leverage in options and the hedging behavior of options sellers. These empirical results contrast with classical asset pricing where options instead derive their value from their underlying assets. Chapter 2, "Disagreement and the Option Stock Volume Ratio," examines a variable known as the option stock volume ratio, which prior work has documented to be a negative predictor of stock returns in the cross section. I propose an alternate explanation based on the behavioral finance literature on belief disagreement between investors. I show how my disagreement model makes predictions in line with prior empirical findings and can also better explain other stylized facts, which I document. Chapter 3, "Bond Fire Sales and Government Interventions," analyzes how a government should intervene in response to a fire sale in the bond market. I contrast the policies of the government directly purchasing financial securities vs the government offering leverage to the private sector to purchase securities.