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Liquidity considerations in estimating implied volatility

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  • Rohini Grover

    (Indira Gandhi Institute of Development Research)

  • Susan Thomas

    ()
    (Indira Gandhi Institute of Development Research)

Abstract

Some option series in the market are far less liquid than others. Market illiquidity can reduce the informativeness of option prices. In this paper, we propose alternative schemes to estimate implied volatility while reducing the importance attached to illiquid options. Using data for index options traded at the National Stock Exchange in India, we and that the performance of a liquidity weighted scheme is superior to that of more conventional schemes such as the vega weights, the volatility elasticity weights and the traditional vxo. Liquidity weights offers the possibility of improved implied volatility estimation in situations where there is strong cross-sectional variation in option market liquidity.

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Bibliographic Info

Paper provided by Indira Gandhi Institute of Development Research, Mumbai, India in its series Indira Gandhi Institute of Development Research, Mumbai Working Papers with number 2011-006.

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Length: 38 pages
Date of creation: Mar 2011
Date of revision:
Handle: RePEc:ind:igiwpp:2011-006

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Keywords: liquidity; implied volatility; volatility index; Indian index options market;

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  1. Peter Reinhard Hansen & Asger Lunde & James M. Nason, 2003. "Choosing the best volatility models: the model confidence set approach," Working Paper, Federal Reserve Bank of Atlanta 2003-28, Federal Reserve Bank of Atlanta.
  2. Blair, Bevan J. & Poon, Ser-Huang & Taylor, Stephen J., 2001. "Forecasting S&P 100 volatility: the incremental information content of implied volatilities and high-frequency index returns," Journal of Econometrics, Elsevier, Elsevier, vol. 105(1), pages 5-26, November.
  3. Ralf Becker & Adam Clements, 2007. "Are combination forecasts of S&P 500 volatility statistically superior?," NCER Working Paper Series, National Centre for Econometric Research 17, National Centre for Econometric Research.
  4. Menachem Brenner, 2001. "The Price of Options Illiquidity," Journal of Finance, American Finance Association, American Finance Association, vol. 56(2), pages 789-805, 04.
  5. Heynen, Ronald & Kemna, Angelien & Vorst, Ton, 1994. "Analysis of the Term Structure of Implied Volatilities," Journal of Financial and Quantitative Analysis, Cambridge University Press, Cambridge University Press, vol. 29(01), pages 31-56, March.
  6. U. ´┐Żetin & 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, Society for Financial Studies, vol. 19(2), pages 493-529.
  7. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, American Finance Association, vol. 51(5), pages 1611-32, December.
  8. Christensen, B. J. & Prabhala, N. R., 1998. "The relation between implied and realized volatility," Journal of Financial Economics, Elsevier, Elsevier, vol. 50(2), pages 125-150, November.
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Blog mentions

As found by EconAcademics.org, the blog aggregator for Economics research:
  1. The rupee: Frequently asked questions
    by Ajay Shah in Ajay Shah's blog on 2011-12-01 18:26:00
  2. Interesting readings
    by Ajay Shah in Ajay Shah's blog on 2011-05-20 04:33:00
  3. New insights into the events on the Indian stock market in the mid-1990s
    by Ajay Shah in Ajay Shah's blog on 2012-04-11 17:22:00
  4. New insights into the events on the Indian stock market in the mid-1990s
    by Ajay Shah in Citizen Economists on 2012-04-13 19:10:04
  5. The rupee: Frequently asked questions
    by Ajay Shah in Citizen Economists on 2011-12-02 14:50:18
  6. Interesting Readings for May 20, 2011
    by Ajay Shah in Citizen Economists on 2011-05-20 17:20:24

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