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Illiquidity Premia in the Equity Options Market

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  • Peter Christoffersen

    ()
    (University of Toronto - Rotman School of Management and CREATES)

  • Ruslan Goyenko

    ()
    (McGill University - Faculty of Management)

  • Kris Jacobs

    ()
    (University of Houston - C.T. Bauer College of Business)

  • Mehdi Karoui

    ()
    (McGill University)

Abstract

Illiquidity is well-known to be a signi?cant determinant of stock and bond returns. We report on illiquidity premia in equity option markets. An increase in option illiquidity decreases the current option price and predicts higher expected option returns. This effect is statistically and economically signi?cant. It is robust across different empirical approaches and when including various control variables. The illiquidity of the underlying stock affects the option return negatively, consistent with a hedging argument: When stock market illiquidity increases, the cost of replicating the option goes up, which increases the option price and reduces its expected return.

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Bibliographic Info

Paper provided by School of Economics and Management, University of Aarhus in its series CREATES Research Papers with number 2011-43.

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Length: 47
Date of creation: 19 Apr 2011
Date of revision:
Handle: RePEc:aah:create:2011-43

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Web page: http://www.econ.au.dk/afn/

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Keywords: illiquidity; equity options; cross-section; option returns; option smile.;

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