Liquidation Cascade and Hedging Front-Running: Evidence from the Structured Equity Product Market

Abstract

We show that structured equity derivatives could cause a significant price dislocation of the underlying stock upon an event of dramatic payoff change. Moreover, one event causes another: the event cascade amplifies the magnitude of the impact. We find that a single event accounts for -6.4% return on the event day, and it increases the probability of a subsequent event by 21.3%. Given the negative price impact, traders try to liquidate ahead of each other, exacerbating the degree of price dislocation. Our results uncover the chain-reaction and (mis)coordination mechanism in complex derivatives markets that could provoke a substantial price shock.