Excess Cash and Equity Option Liquidity

This study examines the relationships between excess corporate cash holding and equity option market liquidity over the period from Jan 3, 2005 to Dec 31, 2019. We show that the level of cash reserve in excess of what can be captured by firm characteristics significantly explains the liquidity of stock options. Trading volume and open interests of the options increase in companies with a higher magnitude of excess cash while the bid-ask spreads of stock options decline in excess cash. Our findings confirm the theoretical predictions by Gopalan et al. (2012) that excess cash improves market liquidity as it reduces adverse selection problems caused by the uncertainty in firm valuations. This relation remains more pronounced with put options, out-of-the money contracts or those with short maturities. In addition, excess cash has stronger impacts on option liquidity within firms with a greater degree of informed trading or during periods of high volatility in financial markets. Our result shows that when the uncertainty about prospects of firms rises, excess cash becomes more valuable and affects option market liquidity.