EQUITY DERIVATIVES: REGULATION AND UNCERTAINTY A DISSERTATION SUBMITTED TO THE DEPARTMENT OF ECONOMICS AND THE COMMITTEE ON GRADUATE STUDIES OF STANFORD UNIVERSITY IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY Elizabeth Connor Stone July 2010 © 2010 by Elizabeth Connor Stone. All Rights Reserved. Re-distributed by Stanford University under license with the author. This work is licensed under a Creative Commons Attribution- Noncommercial 3.0 United States License. http://creativecommons.org/licenses/by-nc/3.0/us/ This dissertation is online at: http://purl.stanford.edu/bp567tk3535 ii I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy. Nicholas Bloom, Primary Adviser I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy. Nir Jaimovich I certify that I have read this dissertation and that, in my opinion, it is fully adequate in scope and quality as a dissertation for the degree of Doctor of Philosophy. Monika Piazzesi Approved for the Stanford University Committee on Graduate Studies. Patricia J. Gumport, Vice Provost Graduate Education This signature page was generated electronically upon submission of this dissertation in electronic format. An original signed hard copy of the signature page is on file in University Archives. iii Abstract The synthesizing element of this dissertation is the use of financial data to research topics relevant for the regulation of financial markets and for policy aimed at stimulating economic activity. The first chapter, entitled “The Effect of Uncertainty on Investment: Evidence from Options" and co-authored with Luke Stein, uses information incorporated in securities prices to understand firm behavior. In particular, the research presents new empirical evidence on the relationship between uncertainty and firm-level investment. The chapter’s contributions fall into two categories: measurement and identification. We use the expected volatility of stock prices as implied by equity options as a proxy for the uncertainty faced by firms. Rather than relying on econometric methods to generate a forecast of future stock price volatility using information in past volatility, the implied volatility from an equity option is the market’s own forecast of explicitly forward-looking uncertainty. In addition, we introduce a natural instrument strategy that relies upon variation in firms’ exposure to the volatility of energy prices and currency exchange rates. These instruments are appealing in their ability to capture factors that are fundamentally relevant for the uncertainty faced by firms. Results are reported for both Ordinary Least Squares and Two-Stage Least Squares estimations. We find a negative and statistically significant relationship between uncertainty and investment that is robust across a variety of specifications. The coefficient estimates are larger in magnitude after addressing the endogeneity of the uncertainty measure, suggesting potential reverse causation that biases the OLS estimates towards zero. The second and third chapters use financial data to analyze topics capturing regulatory attention in equity markets. The second chapter evaluates the Securities Exchange Commission’s implementation of a “penny pricing" pilot in the exchange-traded equity options market in February 2007. The initial phase of this trial required options exchanges to reduce the minimum bid-offer spread from five or ten cents to a penny for the options corresponding to thirteen underlying equity securities. The catalyst for this pricing change was the improved electronic capabilities of the exchanges. Over the course of the preceding decade, the exchanges invested in the development of electronic trading systems that allowed for more efficient quoting and trading of options securities. The SEC’s mandated pricing change effectively redistributes the gains of innovation from the exchanges’ market makers to individual investors. iv The chapter presents an analysis of the market impact of the Penny Pilot and highlights the SEC’s central role in shaping the options market’s innovations and competitive environment. Beyond a reduction in bid- offer spreads, the pilot has stimulated a variety of changes in trading dynamics and market structure. These repercussions include thinner markets, changes in market maker fee structures, the introduction of alternative trading venues, and incentives for the exchanges to prioritize further technological innovation. The third chapter, entitled “Fails to Deliver: The Price Impact of Naked Short Sales", presents research on the effect of naked short selling on asset prices and trading dynamics. This is a prominent topic of debate among academic researchers, market participants, regulators, and the popular press. The chapter evaluates the validity of the claim that naked shorting leads to negative excess returns by creating additional selling pressure. While data on naked short sales is not available, Securities Exchange Commission data on failures to deliver is a strong proxy. Fail to deliver data for 2004 covers a period during which the prevalence of naked short selling was not public knowledge since neither the fail to deliver data nor the Regulation SHO Threshold List was publicly available. In excluding information and regulation effects, the analysis isolates potential microstructure price effects. Using a methodology that constructs daily portfolios according to the quantity of naked short selling, I find no evidence that stocks subject to naked short selling experience negative excess returns. Rather, I find evidence that these stocks outperform on the day the trades occur. Naked short sellers appear to target stocks that outperform during the trading day and cover existing fails on days when the stocks underperform. This outperformance is not evident for stocks subject to the greatest amount of naked short selling, suggesting that positive excess returns may be offset by the additional selling pressure. v Acknowledgments My research has greatly benefited from the advice and guidance of faculty and fellow students at Stanford University. Special thanks to Paul A. David and to the members of my Dissertation Reading Committee: Nicholas Bloom, Nir Jaimovich and Monika Piazzesi. Thank you to Luke Stein, the co-author of the first chapter of my dissertation, for his inspiring commitment to academic excellence. As always, thank you to my family for encouraging my academic and career pursuits and for their unfailing support in times of both challenge and success. vi Contents 1 The Effect of Uncertainty on Investment: Evidence from Options1 1.1 Introduction...........................................1 1.2 Theoretical Foundations....................................3 1.3 Empirical Evidence.......................................4 1.4 Data Overview.........................................5 1.5 “Naïve” Estimation.......................................8 1.6 Instrumental Variables Estimation............................... 13 1.6.1 Endogeneity of Uncertainty.............................. 13 1.6.2 Endogeneity of Tobin’s q ................................ 16 1.6.3 Two-Stage Least Squares Results........................... 18 1.7 Conclusion........................................... 20 1.8 Appendix............................................ 22 1.8.1 Data........................................... 22 1.8.2 Robustness of Timing Assumption........................... 29 1.8.3 Alternative Implied Volatility Durations........................ 29 1.8.4 Alternative Energy Intensity Measure......................... 30 1.8.5 OLS Regressions for Non-FIRE Data Sample..................... 32 1.8.6 Results Using Realized Volatility Measure....................... 33 1.8.7 Relationship Between Implied Volatility and Tobin’s q ................ 34 Bibliography............................................. 35 2 Regulated Technology Diffusion: The SEC and the Impact of Penny Pricing in Electronic Op- tions Trading 39 2.1 Introduction........................................... 39 2.2 Implementation of the Penny Pilot............................... 41 2.3 Market Impact.......................................... 42 vii 2.3.1 Data........................................... 44 2.3.2 Descriptive Statistics.................................. 46 2.3.3 Liquidity Analysis................................... 49 2.3.4 Probit Analysis..................................... 53 2.3.5 Transition Dynamics.................................. 57 2.4 Market Structure Changes................................... 59 2.4.1 Maker Taker...................................... 60 2.4.2 Institutional Investors and Alternative Trading Venues................ 60 2.4.3 Incentives for Further Technological Progress..................... 62 2.5 Conclusion........................................... 62 2.6 Appendix............................................ 64 2.6.1 Control Selection.................................... 64 2.6.2 Robustness to Inclusion of Observations with Zero Trading Volume......... 68 Bibliography............................................. 69 3 Fails to Deliver: The Price Impact of Naked Short Sales 71 3.1 Introduction........................................... 71 3.2 Literature Review........................................ 73 3.3 Finnerty Model......................................... 74 3.4