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

Trillions of dollars of derivatives are trading in many markets regularly, but little is known about the direct interactions between different types of derivatives referencing the same firm. This study is the first to examine the impact of credit derivatives on equity derivatives. We show that equity options of firms with credit default swaps (CDS) are more expensive than non-CDS firms' options. Our main results are based on delta-hedged option returns. The CDS effect on options is robust to different measures of option pricing and sample period, likely to be causal, and is stronger when the funding costs for derivatives dealers are higher. Our findings are consistent with the view that derivatives pricing is influenced by dealers' intermediation capacity and supportive of the intermediary asset pricing theory