Does the Introduction of One Derivative Affect Another Derivative? The Effect of Credit Default Swaps Trading on Equity Options

Although the impact of derivatives trading on underlying firms’ securities is extensively examined, the interactions between different types of derivatives remain underexplored. In this study, we show that options on the stocks of companies with credit default swaps (CDS) are more expensive, as indicated by lower delta-hedged option returns. This result is consistent with the view that option premiums are influenced by dealers’ intermediation capacity, which is adversely impacted by CDS trading. Nevertheless, options associated with CDS exhibit improved market quality (e.g., higher liquidity, lower pricing error), suggesting cross-market information spillover from CDS to options.