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Liquidity Costs in Futures Options Markets

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  • Shah, Samarth
  • Brorsen, B. Wade
  • Anderson, Kim B.

Abstract

The major finding is that liquidity costs in futures options market are two to three times higher than liquidity costs in the futures market. Liquidity cost is one potential factor to consider when choosing between hedging with a futures contract or with an option contract. While there is considerable research that estimates liquidity costs of futures trading, there is little comparable research about options markets. This study, for the first time, attempts to determine and compare liquidity costs in options and futures markets. The study uses July 2007 wheat futures and options contracts traded on Kansas City Board of Trade. Two measures of liquidity costs were used for both options and futures markets. One measure of liquidity costs in options markets is the average bid-ask spread that is calculated from the available bidask quotes. A new measure of liquidity costs in options markets is derived based on the Black model and it uses trade prices instead of observed bid-ask quotes. The liquidity costs in the options market was estimated to be 1.60 cents per bushel using observed bid-ask spreads and it was 1.37 cents per bushel when the new measure was used. Liquidity costs in the futures markets are estimated using Roll’s measure and average absolute price changes. The estimates were 0.45 and 0.49 cents per bushel, respectively for futures contracts. A positive relation was found between option liquidity costs and moneyness of the option. Days to expiration of the contracts was not statistically significant in explaining the liquidity cost of the option.

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Bibliographic Info

Paper provided by NCCC-134 Conference on Applied Commodity Price Analysis, Forecasting, and Market Risk Management in its series 2009 Conference, April 20-21, 2009, St. Louis, Missouri with number 53047.

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Date of creation: Apr 2009
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Handle: RePEc:ags:nccc09:53047

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Related research

Keywords: Bid-ask spread; Black model; KCBT; liquidity costs; options; Agribusiness; Agricultural Finance; Financial Economics; Risk and Uncertainty;

References

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  1. Thompson, Sarahelen R. & Eales, James S. & Seibold, David, 1993. "Comparison Of Liquidity Costs Between The Kansas City And Chicago Wheat Futures Contracts," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 18(02), December.
  2. Thompson, S. & Waller, M.L., 1988. "Determinants Of Liquidity Costs In Commodity Furures Markets," Papers 172, Columbia - Center for Futures Markets.
  3. Townsend, John P. & Brorsen, B. Wade, 1997. "Cost of Forward Contracting Hard Red Winter Wheat," 1997 Annual Meeting, July 13-16, 1997, Reno\Sparks, Nevada 35749, Western Agricultural Economics Association.
  4. B. Wade Brorsen & John Coombs & Kim Anderson, 1995. "The cost of forward contracting wheat," Agribusiness, John Wiley & Sons, Ltd., vol. 11(4), pages 349-354.
  5. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
  6. Baesel, Jerome B & Shows, George & Thorp, Edward, 1983. " The Cost of Liquidity Services in Listed Options: A Note," Journal of Finance, American Finance Association, vol. 38(3), pages 989-95, June.
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Cited by:
  1. Elam, Emmett W., 1992. "Cash Forward Contracting Versus Hedging Of Fed Cattle, And The Impact Of Cash Contracting On Cash Prices," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 17(01), July.
  2. Carl R. Zulauf & Scott H. Irwin, 1997. "Market Efficiency and Marketing to Enhance Income of Crop Producers," Finance 9711004, EconWPA.
  3. Thompson, Sarahelen R. & Eales, James S. & Seibold, David, 1993. "Comparison Of Liquidity Costs Between The Kansas City And Chicago Wheat Futures Contracts," Journal of Agricultural and Resource Economics, Western Agricultural Economics Association, vol. 18(02), December.

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