Market makers’ optimal price-setting policy for exchange-traded certificates

Abstract

This paper considers the pricing of certificates on exchanges for retail investors. The contribution to the literature is twofold: (i) We provide the first theoretical model that analyzes the optimal, i.e. profit-maximizing price-setting policy of the issuer over a certificate's life time. Our model derives and examines the nexus between optimal markup and optimal spread inter-temporally set by the issuer, unhedgeable risk faced by the issuer, and investors' buying and selling decisions. (ii) Analyzing the German market for leverage certificates, we provide the first comprehensive empirical analysis of model-derived hypotheses on the issuers' pricing policies that accounts for possible endogeneity between markup and spread and concretizes the effects of unhedgeable risk, volume and order flow.

Volatility discovery and volatility quoting on markets for options and warrants

“…Strikingly, all of the nine averaged ISV curves have a significant negative slope, when in fact the averaged VDAX has a small positive gradient. Hence, in line with the demand pattern reported by Baller et al (2016), a decrease in volatility quoting over time might reflect the intention of issuers to exploit the trading behavior of investors: In the early hours, net demand is higher, while in the late hours more investors tend to sell their warrants back to the issuer. The size of this effect is considerable: the reduction in implied volatility over the day ranges from −4 basis points (HSBC) to −15 basis points (Vontobel), on average, while the VDAX increases by 1.5 basis points.…”

“…Baller et al (2016) present a theoretical model and an extensive empirical study of the intra-day pricing behavior of leverage certificate issuers. So while these effects work in opposite directions, Baller et al (2016) show that the first is stronger, as issuers tend to increase their mark-ups over a trading day on average. This risk increases during the day, so it is reasonable for issuers to increase their quotes during a trading day.…”

“…For leverage certificates, a popular retail product with some similarities to bank-issued warrants, Entrop et al (2013) show that banks increase their mark-ups with respect to the theoretical fair value during a trading day. Baller et al (2016) present a theoretical model and an extensive empirical study of the intra-day pricing behavior of leverage certificate issuers. They outline two major effects which might influence this behavior: First, leverage certificates face an overnight jump risk of the underlying, since they may be knocked out over night with a loss in the hedge portfolio of the issuer.…”

“…Baller, Entrop, McKenzie, and Wilkens (2016) demonstrate that on average banks increase their quotes for similar products, the leverage certificates, during a trading day. If issuers play a relevant role in volatility discovery, then sources of information flow could be traced to the more informed, price-determining issuers, as the quotes of each single issuer are observable separately.…”

“…If they mainly reflect volatility information from the options market, a closer look at their volatility quoting behavior-aside from information-driven pricing-would be possible. Baller, Entrop, McKenzie, and Wilkens (2016) demonstrate that on average banks increase their quotes for similar products, the leverage certificates, during a trading day. The question is whether such behavior also applies to warrants.…”