Abstract

Derivatives markets can quickly become illiquid in periods of high uncertainty. Neither the source of this illiquidity nor its implications are well understood. First, this thesis shows that hedgers' trades have an adverse impact on the futures price creating effectively an endogenous transaction cost increasing in times of uncertainty and acting as the source of illiquidity in these markets. Second, illiquidity is shown to strengthen the wealth effect, which has been proven to be too weak empirically to explain the behavior of prices. The wealth effect is the mechanism through which changes in investors' wealth impact their attitude towards risk. As investors lose wealth, they become more risk averse and ask for a higher compensation to hold a risky asset thereby decreasing its price. Third, illiquidity is shown to potentially explain the shape of the implied volatility function not only as a function of moneyness but also of the options' volume or open interest. These results are derived from models, where producers maximize their expected utility derived from their profits. They seek to hedge the uncertain price at which they will sell their product in the future. They can use futures or put options to reduce this price risk but must pay speculators, defined as having no position in the underlying asset, a premium. This premium disappears normally as trades are assumed to be too small to matter and the risk of trading perfectly shared. Both of these assumptions are relaxed to derive the illiquidity transaction costs and its implications.