Competition in equity option markets

This dissertation examines competition between exchanges that trade equity options. In Chapter Two, I allow exchanges to make strategic entry decisions by employing a discrete choice model using exchange entry patterns as a signal of the underlying profitability in each option market. I estimate latent profit equations for exchanges as a function of the underlying company's characteristics and the pattern of entry. This work extends the emerging literature on competition between option exchanges through its use of a novel econometric approach. I also extend the existing discrete choice literature on firm entry by estimating the effect of entry by specific exchanges on their competitors' profits. I find that the presence of smaller exchanges has a large effect on the entry probability of major exchanges, while major exchanges only exert a moderate influence on the entry probability of other major exchanges. The analysis also reveals that asset size, volatility, and trading volume of the underlying stock are significantly and positively related to exchange entry decisions.; I extend the research in Chapter Three by developing a joint model of exchange entry and the bid-ask spread in equity option markets. To my knowledge, no other study of the spread in financial markets has incorporated the exchange decision about whether or not to list a security. This allows me to achieve identification in a unique way. I find statistically significant correlation between exchange entry decisions and bid-ask spreads, but the magnitude of the correlation is small. Further, I find that Ordinary Least Squares regression of the bid-ask spread misstates the effect of specific exchanges. In a study of 474 markets affected by an alleged conspiracy between the exchanges during the 1990s, I predict a median decline of 8 cents in spreads by the additional entry that should have occurred.