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The impact of liquidity on option prices

Authors


  • We would like to thank Chuang-Chang Chang, Hsuan-Chi Chen, Ren-Raw Chen, Jin-Chuan Duan, Bernard Lee, Bing-Huei Lin, Mark Seasholes, Keshab Shrestha, Bob Webb (Editor), Chung-Ying Yeh, Shih-Kuo Yeh, and seminar participants at the NUS Risk Management Institute and the 21st annual Asia-Pacific Futures Research Symposium for their helpful comments. The authors are also grateful to the National Science Council of Taiwan for the financial support provided for this study.

Abstract

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. © 2011 Wiley Periodicals, Inc. Jrl Fut Mark

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