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

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  • U. Çetin
  • R. Jarrow
  • P. Protter
  • M. Warachka

Abstract

This article studies the pricing of options in an extended Black Scholes economy in which the underlying asset is not perfectly liquid. The resulting liquidity risk is modeled as a stochastic supply curve, with the transaction price being a function of the trade size. Consistent with the market microstructure literature, the supply curve is upward sloping with purchases executed at higher prices and sales at lower prices. Optimal discrete time hedging strategies are then derived. Empirical evidence reveals a significant liquidity cost intrinsic to every option. Copyright 2006, Oxford University Press.

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  • U. Çetin & R. Jarrow & P. Protter & M. Warachka, 2006. "Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence," Review of Financial Studies, Society for Financial Studies, vol. 19(2), pages 493-529.
  • Handle: RePEc:oup:rfinst:v:19:y:2006:i:2:p:493-529
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    1. Leland, Hayne E, 1985. "Option Pricing and Replication with Transactions Costs," Journal of Finance, American Finance Association, vol. 40(5), pages 1283-1301, December.
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    6. Rubinstein, Mark, 1985. "Nonparametric Tests of Alternative Option Pricing Models Using All Reported Trades and Quotes on the 30 Most Active CBOE Option Classes from August 23, 1976 through August 31, 1978," Journal of Finance, American Finance Association, vol. 40(2), pages 455-480, June.
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    JEL classification:

    • B26 - Schools of Economic Thought and Methodology - - History of Economic Thought since 1925 - - - Financial Economics
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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