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AbstractWe provide evidence of a strong effect of the underlying stock's illiquidity on option prices by showing that the average absolute difference between historical and implied volatility increases with stock illiquidity. This pattern translates into significant excess returns of option trading strategies that are not explained by common risk factors. Simulation results show, however, that our results can be explained by the hedging costs of market makers who are net long in options on some underlyings and net short in options on other underlyings. Our empirical findings are robust with respect to the chosen illiquidity measure, the measure of option expensiveness, and the return period.
JEL Classification: G12; G13Keywords: Illiquidity, equity options, option returns, option strategiesWe are grateful for helpful comments from
Valuation heuristics are widely used to value traditional time vesting option plans. This study analyses if these heuristics also qualify for valuing performance vesting plans. We examine performance conditions tied to the underlying stock, the stock's performance relative to a stock index, and an earnings measure. The differences between the approximated option values and the values assuming optimal exercise are overall smaller with the performance conditions than without them. In particular, this result holds when the heuristic exercise assumptions are based on the case without performance conditions, which is a considerable simplification in practice.
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