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Implied liquidity risk premia in option markets

Author

Listed:
  • Florence Guillaume

    (University of Antwerp)

  • Gero Junike

    (Universitat Autònoma de Barcelona)

  • Peter Leoni

    (University of Leuven)

  • Wim Schoutens

    (University of Leuven)

Abstract

The theory of conic finance replaces the classical one-price model by a two-price model by determining bid and ask prices for future terminal cash flows in a consistent manner. In this framework, we derive closed-form solutions for bid and ask prices of plain vanilla European options, when the density of the log-returns is log-concave. Assuming that log-returns are normally or Laplace distributed, we apply the results to a time-series of real market data and compute an implied liquidity risk premium to describe the bid–ask spread. We compare this approach to the classical attempt of describing the spread by quoting Black–Scholes implied bid and ask volatilities and demonstrate that the new approach characterize liquidity over time significantly better.

Suggested Citation

  • Florence Guillaume & Gero Junike & Peter Leoni & Wim Schoutens, 2019. "Implied liquidity risk premia in option markets," Annals of Finance, Springer, vol. 15(2), pages 233-246, June.
    • Handle: RePEc:kap:annfin:v:15:y:2019:i:2:d:10.1007_s10436-018-0339-y
    DOI: 10.1007/s10436-018-0339-y
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    References listed on IDEAS

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    1. Kijima, Masaaki & Muromachi, Yukio, 2008. "An extension of the Wang transform derived from Bühlmann's economic premium principle for insurance risk," Insurance: Mathematics and Economics, Elsevier, vol. 42(3), pages 887-896, June.
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    9. Albrecher, Hansjoerg & Guillaume, Florence & Schoutens, Wim, 2013. "Implied liquidity: Model sensitivity," Journal of Empirical Finance, Elsevier, vol. 23(C), pages 48-67.
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    11. Dilip B. Madan & Alexander Cherny, 2010. "Markets As A Counterparty: An Introduction To Conic Finance," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 13(08), pages 1149-1177.
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    Cited by:

    1. Yerli, Cigdem & Eksi-Altay, Zehra & Selcuk-Kestel, A. Sevtap, 2023. "On the information content of implied liquidity measure: Evidence from the S&P 500 index options," Finance Research Letters, Elsevier, vol. 57(C).
    2. Gero Junike, 2023. "On the number of terms in the COS method for European option pricing," Papers 2303.16012, arXiv.org, revised Mar 2024.

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    More about this item

    Keywords

    Conic finance; Distortion functions; WANG-transform; Laplace distortion;
    All these keywords.

    JEL classification:

    • C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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