Abstract
A significant event for equity options since the 1987 stock market crash is the rise of credit default swaps (CDS). We show that equity options of CDS-referenced firms are more expensive than those without CDS. Instrumental variable estimation and other analysis suggest that the CDS effect on option pricing is likely causal. Transactions data reveal that brokers and dealers’ demand is higher for options linked to CDS. The effect of CDS trading on option pricing is more pronounced when financial institutions have less capital or higher leverage. Our findings are consistent with theories that intermediation capacity constraints affect derivatives pricing.
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