Do Derivatives Matter?: Evidence From A Policy Experiment

We study the impact of derivatives on various stock characteristics such as valuation, price efficiency, and liquidity. We resolve the endogeneity issue faced in the extant literature by using an order issued by the Indian market regulator that resulted in the delisting of 51 stocks from the derivative segment. Using this policy experiment, we examine the conflicting hypothesis regarding the impact of derivatives on stock fundamentals. We find that excluded firms underperform the market by 4.07% during the event window. We identify a decline in price efficiency and reduction in liquidity as channels through which the above phenomenon manifests. Contrary to the expectations of the regulators, volatility remains largely unchanged. We rule out regulatory targeting by employing several placebo and robustness tests. We conclude that derivatives indeed add value by improving price efficiency and liquidity of a stock.