Digital Contracts and Price Manipulation*

Abstract

Corporate insiders holding derivative contracts on their firm's stock have an incentive to engage in stock price manipulation. I examine several derivative contracts susceptible to manipulation and the price impact of the insiders' strategic behavior. Digital contracts, the basic building blocks for valuing complex financial derivatives, are vulnerable to manipulation. The impact of the strategies from holding digital contracts is consistent with an implied volatility skew and volatility clustering. Even seemingly innocuous derivatives, such as ordinary bull spreads, generate these manipulation incentives. This has strong implications for corporate policy, since firms often use option spreads in their stock repurchase programs.