A dark side to options trading? Evidence from corporate default risk.

Does options trading increase or decrease corporate default risk? We answer this question by examining how options trading affects the expected default frequency. The results reveal a positive correlation between equity options trading and future corporate default risk. A single-standard-deviation increase in options trading volume is associated with an increase of over 3% in the expected default probability. Using actual defaults as well as the CDS spread as an alternative proxy for default risk yields consistent results. To corroborate this evidence, we use several econometric specifications, including instrumental variables and the Penny Pilot Program of the Chicago Board Options Exchange as an exogenous shock for the quasi-natural experiment. Moreover, the positive effect of options trading on default risk is more pronounced when firms are more financially distressed and when the CEO holds a smaller stake of inside debt. Further evidence suggests that options trading induces excessive corporate risk-taking activities that destroy firm value and increases CEO compensation convexity. Overall, the results are consistent with an active options market increasing firm default risk by inducing excessive shifting of risk. [ABSTRACT FROM AUTHOR]