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Jump risk and option liquidity in an incomplete market
Author(s) -
Hsieh PeiLin,
Zhang QinQin,
Wang Yajun
Publication year - 2018
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.21934
Subject(s) - jump , econometrics , jump diffusion , bernoulli's principle , market liquidity , volatility (finance) , ask price , economics , mathematics , actuarial science , monetary economics , finance , physics , quantum mechanics , thermodynamics
This study investigates the effect of a jump risk on options’ bid–ask implied volatility (IMV) spreads. We introduce theoretical models assuming market makers encounter a Bernoulli‐type jump atnd optimize the mean‐variance utility by choosing the optimal hedging delta and price. We find, at a low jump arrival rate, the Black–Scholes–Merton dynamic hedging for diffusion volatility outperforms static hedging for both diffusion and jump risks. If dynamic hedging is implemented, the jump components nonlinearly affect bid–ask spreads. Our regression supports our theoretical conclusions, and for model‐free IMV, jump risk factors are characterized by t statistics above 7 with adjusted R 2 above 70%.