Abstract
Using an exogenous reduction in margin requirements, this paper shows that funding liquidity causally affects market liquidity. On July 14, 2005 the Securities and Exchange Commission approved a pilot program that permitted portfolio margining of index options but not equity options. The resulting significant improvement of funding liquidity leads to an increase in trading volume, a decrease bid-ask spread, and a decrease in price impact for index options compared to the unaffected equity options. These results provide strong causal evidence in support of the theories presented by Gromb and Vayanos (2002) and Brunnermeier and Pedersen (2009).
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