Applied Econometrics, Corporate Finance, Financial Economics

1. The introduction of exchange-listed options improves a firm’s information environment, reducing informational frictions and enabling greater external capital access, increased equity financing, lower leverage, and more efficient investment and innovation.
2. The study uses a regression discontinuity design and instrumental variables based on SEC listing rules to establish a causal link between options availability and positive corporate policy changes.
3. Options markets create positive spillovers by making equity prices more informative and enabling improved investor monitoring.

Corporate finance theory suggests that the quality of a firm’s information environment affects its overall access to external funds and its access to equity financing. Information quality also affects investment policy because reduced information asymmetry reduces investment risk and makes external capital more readily available.

Although a firm’s information environment depends on many features, including financial analyst coverage, institutional ownership, and disclosure quality, the variations in these features impact on a firm’s decisions.

In this study, the researchers examined the effects of information on corporate decision-making by exploring a unique shock to a firm’s information environment. This shock is the introduction of exchange-listed options. These are an ideal research setting for this analysis because they are significant and frequent events, staggered over a long period of time, and are decided by the exchange without a firm’s involvement.

By accounting for endogeneity concerns, the study’s empirical analysis supports the premise that exchange-listed options mitigate informational frictions and have real effects on corporate actions. 

Although options are introduced to allow investors to hedge and/or take speculative positions, study results show that options introductions also have an unintended and important positive spillover effect on corporate decisions concerning both sides of the balance sheet. Improved information quality results in greater investment as well as increased and superior innovation. Improved information quality also reduces the need to use payout and debt to address agency and information frictions. The study combined a regression discontinuity design (RDD) analysis with a new instrumental variable (IV), which allowed the researchers to clearly identify the causal effect of options availability on:

1. Equity and debt issues.
2. Financial leverage.
3. Repurchase intensities and dividend payout.
4. Investment intensities and quality.
5. Cash holdings.
6. Innovation activities.

All tests relied on options availability to assess their impact on corporate policies. The researchers found that when firms’ equity is linked to listed options, firms raise more external capital, rely more heavily on equity financing, reduce leverage, reduce payout, invest in greater quantity, build larger cash reserves, and invest more efficiently.

The IVs measured the eligibility of a firm for the treatment of options listings. This exploited the random variations in the likelihood of having options due to either satisfying or failing to satisfy the regulatory requirements. Intuitively, the IVs should have the best ability to identify causal effects from options trading for firms around the regulatory threshold because these firms have similar characteristics. Thus, the researchers conducted an RDD analysis as the main empirical method, by constructing the sample by merging data from the Center for Research in Security Prices (CRSP), Compustat, and OptionMetrics databases for the period of 1996 to 2019. Financial and utilities firms, as well as those with total assets or sales below 1 million USD in Compustat, were excluded.

To overcome selection bias, the researchers drew causal inferences from tests based on an IV approach. The instrument for the availability of listed options exploited the SEC’s requirements that must be satisfied by the underlying stock to be eligible for options listing under the Options Listing Procedures Plan, or OLPP. Eligibility for options listing entailed the following requirements for each stock:

1. A minimum public float of 7 million shares.
2. At least 2.4 million shares traded in the past 12 months.
3. At least 2,000 shareholders.
4. The stock price must be above $7.50.

These requirements provided an advantageous setting to study the treatment effect of options. If two firms fell on opposite sides of a regulatory threshold, the probability of each firm’s stock being linked to listed options would be significantly different even when they have identical fundamental characteristics. From this perspective, and given the intrinsic randomness characterising whether firms meet all SEC listing requirements, these institutional features provided an ideal setting.

The results provide a coherent picture of how improved information quality affects corporate policies. Firms experiencing positive information shocks brought about by options trading would more frequently access external capital, and their behaviour was consistent with the notion that external equity becomes cheaper than debt for these firms. Furthermore, these firms actively managed their capital structure to achieve lower financial leverage, and simultaneously conducted fewer equity buybacks and paid lower dividends. Meanwhile, investors reacted less intensely when these firms decided to raise or retire equity or to change their dividend payout.

Firms with listed options also invested more, innovated more, and built larger cash reserves. Corporate investments also became more sensitive to growth opportunities. Consistent with private information driving the results, the effects of listed options were stronger in weak information environments characterised by low analyst coverage, a high probability of informed trading, low institutional ownership, small market capitalisations, and younger firms.

The study demonstrates that information shocks from innovations in the capital markets have a causal and significant impact on corporate behaviour. Therefore, by rendering underlying equity prices more informative and facilitating monitoring by investors, options market activity feeds back into and enhances the efficiency of firms’ decisions. The evidence shows that option markets are not a sideshow.

Study findings also highlight the significance of spillover effects when evaluating derivatives markets and financial innovations. Even though firms rarely engage in trading on their own options, they still benefit from their introduction. There are positive externalities gained by firms and their shareholders, and such externalities are critical to measuring the impacts of financial innovations. To the extent that similar spillover effects are relevant to other financial innovations, such as credit derivatives or new trading systems, the researchers advocate including them in analyses of their merits.

* Learn more from the full research article here:
https://doi.org/10.1017/S0022109023001229