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The impact of liquidity on option prices
Author(s) -
Chou Robin K.,
Chung SanLin,
Hsiao YuJen,
Wang YawHuei
Publication year - 2011
Publication title -
journal of futures markets
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.88
H-Index - 55
eISSN - 1096-9934
pISSN - 0270-7314
DOI - 10.1002/fut.20531
Subject(s) - market liquidity , economics , volatility (finance) , implied volatility , liquidity premium , econometrics , volatility risk , moneyness , liquidity risk , financial economics , spot contract , volatility smile , monetary economics , volatility risk premium , futures contract
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