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Determining bid-ask prices for options with stochastic illiquidity and applications to index options

Author

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  • Chuang, Ming-Che
  • Tsai, Jeffrey Tzuhao

Abstract

Market makers must quote two prices - bid and ask prices - for options. This article provides a GARCH model with stochastic illiquidity risks and gives analytical approximation solutions for the bid and ask prices for options. A joint calibration method is applied for calibrating the implied parameters. The empirical evidence shows an illiquidity smile for short-term calls and a negatively sloped illiquidity smirk for long-term calls. Similar results are also observed in put option prices. The proposed stochastic illiquidity model significantly outperforms the static illiquidity model in the in-sample and out-of-sample tests, particularly when the stochastic volatility is crucial.

Suggested Citation

  • Chuang, Ming-Che & Tsai, Jeffrey Tzuhao, 2024. "Determining bid-ask prices for options with stochastic illiquidity and applications to index options," Pacific-Basin Finance Journal, Elsevier, vol. 84(C).
    • Handle: RePEc:eee:pacfin:v:84:y:2024:i:c:s0927538x24000659
    DOI: 10.1016/j.pacfin.2024.102314
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    More about this item

    Keywords

    Stochastic illiquidity; Illiquidity smile; Illiquidity smirk; Joint calibration; Coherent risk measure; Fourier cosine series expansion;
    All these keywords.

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C46 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Specific Distributions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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