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The impact of liquidity on option prices

✍ Scribed by Robin K. Chou; San-Lin Chung; Yu-Jen Hsiao; Yaw-Huei Wang

Publisher
John Wiley and Sons
Year
2011
Tongue
English
Weight
148 KB
Volume
31
Category
Article
ISSN
0270-7314

No coin nor oath required. For personal study only.

✦ Synopsis

This study illustrates the impact of both spot and option liquidity levels on option prices. Using implied volatility to measure the option price structure, our empirical results reveal that even after controlling for the systematic risk of Duan and Wei ( 2009), a clear link remains between option prices and liquidity; with a reduction (increase) in spot (option) liquidity, there is a corresponding increase in the level of the implied volatility curve. The former is consistent with the explanation on hedging costs provided by Cetin, Jarrow, Protter, and Warachka (2006), whereas the latter is consistent with the "illiquidity premium" hypothesis of Amihud and Mendelson (1986a). This study also shows that the slope of the implied volatility curve can be partially explained by option liquidity.

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