Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence

Çetın, Umut; Jarrow, Robert A.; Protter, Philip; Warachka, Mitchell Craig

doi:10.1142/9789812819222_0009

Cited by 41 publications

(73 citation statements)

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“…In particular, only the partial derivative of the demand function with respect to the ν‐variable at the origin (i.e., ) is relevant for the continuous‐time solution. Moreover, the empirical analysis of Çetin et al (2006) indicates that this partial derivative is constant. This motivates the linear choice θ t (ν) =Λν for some liquidity parameter Λ > 0.…”

Section: Dynamic Programmingmentioning

confidence: 99%

Liquidity in a Binomial Market

Gökay

Soner

2010

Mathematical Finance

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We study the binomial version of the illiquid market model introduced by Ç etin, Jarrow, and Protter for continuous time and develop efficient numerical methods for its analysis. In particular, we characterize the liquidity premium that results from the model. In Ç etin, Jarrow, and Protter, the arbitrage free price of a European option traded in this illiquid market is equal to the classical value. However, the corresponding hedge does not exist and the price is obtained only in L 2 -approximating sense. Ç etin, Soner, and Touzi investigated the super-replication problem using the same supply curve model but under some restrictions on the trading strategies. They showed that the super-replicating cost differs from the Black-Scholes value of the claim, thus proving the existence of liquidity premium. In this paper, we study the super-replication problem in discrete time but with no assumptions on the portfolio process. We recover the same liquidity premium as in the continuous-time limit. This is an independent justification of the restrictions introduced in Ç etin, Soner, and Touzi. Moreover, we also propose an algorithm to calculate the option's price for a binomial market.

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Section: Dynamic Programmingmentioning

confidence: 99%

Liquidity in a Binomial Market

Gökay

Soner

2010

Mathematical Finance

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“…Furthermore, several studies investigate the effect of liquidity on derivative prices. In an extended Black--Scholes economy, Cetin, Jarrow, Protter, and Warachka (2006) derive the prices of options with illiquid underlying assets. Their empirical results support the conjecture that liquidity costs account for a significant portion of the option price.…”

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confidence: 99%

From funding liquidity to market liquidity: Evidence from the index options market

Liu

Zhang

Zhou

2018

Journal of Futures Markets

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This study examines the relationship between funding liquidity and market liquidity using daily data on the S&P 500 index options. We find that options market liquidity is positively correlated with funding liquidity after controlling for market uncertainty. Further analysis reveals that the positive relationship between funding liquidity and market liquidity in the options market is mainly driven by short‐term and deep out‐of‐the‐money options. Our results remain robust after controlling for the confounding effects of the equity market and different data frequencies.

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“…Predictable differences in volatility should have first‐order effects on option prices (see also Dubinsky and Johannes ()), while varying liquidity should affect not only the option end user but also the market maker who must delta‐hedge his underlying exposure in the stock market (e.g., Cetin et al. ()). Limited attention may be more problematic in option markets, where small changes in fundamentals can have large valuation effects.…”

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confidence: 99%

Option Mispricing around Nontrading Periods

Jones

Shemesh

2018

The Journal of Finance

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We find that option returns are significantly lower over nontrading periods, the vast majority of which are weekends. Our evidence suggests that nontrading returns cannot be explained by risk, but rather are the result of widespread and highly persistent option mispricing driven by the incorrect treatment of stock return variance during periods of market closure. The size of the effect implies that the broad spectrum of finance research involving option prices should account for nontrading effects. Our study further suggests how alternative industry practices could improve the efficiency of option markets in a meaningful way.

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Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence

Cited by 41 publications

References 0 publications

Liquidity in a Binomial Market

Liquidity in a Binomial Market

From funding liquidity to market liquidity: Evidence from the index options market

Option Mispricing around Nontrading Periods

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