Two Essays on Liquidity Essay I: Information Related Trading on Two Nearly Identical Options Essay II: The Importance of the Liquidity Premium in the Presence of Declining Transactions Cost

In the first essay, I examine the impact of the introduction of exchange traded funds (ETFs) options on the information related trading of index options. Two option pairs, NASDAQ 100 index (NDX) and ETF (QQQ, currently QQQQ ) options, and Standard and Poor's 500 index (SPX) options and S & P Depository Receipts (SPY) options, are studied. I test the hypothesis, based on the theory of Chowdhry and Nanda (1991), and Admati and Pleiderer (1988), that the information component of spreads for index options should decline after ETF options were introduced. The method of George, Kaul and Nimalendran (1991) is used to estimate the adverse selection proportion of log quoted spread and revenue from quoted spread. Primary results show that the adverse selection component of index options declines after the introduction of ETF options, and that the adverse selection component of options on index ETFs is greater than that of options on index, suggesting more informed trading for ETF options. The second essay examines whether the liquidity premium decreases as the costs of transactions decline. Nine liquidity measures are estimated to form liquidity deciles portfolios. I use several benchmark asset pricing models in fixed and rolling 36-month samples to estimate time variation liquidity premia. Surprisingly, the results show that the liquidity premium does not monotonically decline over time, and it increases in the period from 2001 to 2006. This is inconsistent with the implication of liquidity-adjusted capital asset pricing models (L-CAPM). It is likely that the liquidity premium is generated by size and book-to-market factors, rather than the liquidity factor.