Volatility Derivatives and Market (Il)liquidity

We study how derivatives (with nonlinear payoffs) affect the liquidity of their underlying assets. In a noisy rational expectations equilibrium, informed investors expect low conditional volatility and sell derivatives to others. These derivative trades affect investors' utility differently, possibly amplifying liquidity risk. As investors delta hedge their derivative positions, price impact in the underlying drops, suggesting improved liquidity, because informed trading is diluted. In contrast, effects on price reversal are ambiguous, depending on investors’ relative delta hedging sensitivity, i.e., the gamma of the derivatives. The model cautions of potential disconnections between illiquidity measures and liquidity risk premium due to derivatives trading.