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Analytically pricing European options in dynamic markets: Incorporating liquidity variations and economic cycles

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  • He, Xin-Jiang
  • Pasricha, Puneet
  • Lin, Sha

Abstract

This paper discusses the European option pricing problem in the context of asset prices being influenced by liquidity risks and economic cycles. We employ regime switching for asset volatility, and liquidity risks are captured by market-wide liquidity. We obtain an analytical formulation of European option prices, allowing for fast model calibration using real-market data. By estimating model parameters using real option data, we show that pricing errors can be significantly reduced using our model that considers stochastic liquidity, indicating that our model has real-world applications. Our results can help investors and regulators better understand the market and provide a potentially effective risk management tool.

Suggested Citation

  • He, Xin-Jiang & Pasricha, Puneet & Lin, Sha, 2024. "Analytically pricing European options in dynamic markets: Incorporating liquidity variations and economic cycles," Economic Modelling, Elsevier, vol. 139(C).
    • Handle: RePEc:eee:ecmode:v:139:y:2024:i:c:s0264999324001962
    DOI: 10.1016/j.econmod.2024.106839
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    Keywords

    Liquidity risks; Regime switching; European options; Characteristic function; Closed form;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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