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Market Maker Inventory, Bid–Ask Spreads, and the Computation of Option Implied Risk Measures

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  • jørn Eraker
  • Daniela Osterrieder

Abstract

We present empirical evidence showing that option-implied risk measures (OIRMs) are substantially impacted by bid–ask spreads in underlying options. Asking prices are more sensitive to shocks than bids, leading to highly skewed distributions of spreads. We derive and estimate a model of market making that empirically matches these asymmetric responses as well as the time-series properties of bid–ask spreads. Using these estimates to obtain bias-corrected option quotes, we compute several popular OIRMs. We find that fear and risk premia associated with market events that affect the center of the return distribution or unpredictable return jumps are on average overstated when relying on option mid-quotes, whereas risk associated with return-tail events is larger once the bias has been corrected.

Suggested Citation

  • jørn Eraker & Daniela Osterrieder, 2023. "Market Maker Inventory, Bid–Ask Spreads, and the Computation of Option Implied Risk Measures," Journal of Financial Econometrics, Oxford University Press, vol. 21(5), pages 1820-1851.
    • Handle: RePEc:oup:jfinec:v:21:y:2023:i:5:p:1820-1851.
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbac025
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    More about this item

    Keywords

    asymmetric bid–ask spreads; biased option mid-quotes; market-maker inventory; option-implied risk measures;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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