Liquidity as an Information Signal: Evidence from Currency Options Market in India

We examine the systematic component of liquidity as source of information signal which lead to price changes in the Indian currency options market. Using daily data from spot and currency options markets for the USD-INR currency, the paper investigates the inter-relationship of currency options liquidity with spot exchange rate returns and volatility, and speculative tendency in the options market. We use modified Amihud (2002) in a time-series framework as a new measure of market-level illiquidity in the currency options market. Cointegration and vector error correction model estimation approaches are employed to examine the causal relationship among illiquidity, volatility, returns and speculation in currency options market. We find that while no evidence for relationship between liquidity and volatility, but spot exchange rate changes are statistically significantly related to options market liquidity. We report that liquidity acts as an information signal for speculators and further drives speculation in the options market for the USD-INR currency pair.