IDEAS home Printed from https://ideas.repec.org/a/ibf/ijbfre/v5y2011i2p35-43.html
   My bibliography  Save this article

The Liquidity Effect In Option Pricing: An Empirical Analysis

Author

Listed:
  • Shih-Ping Feng

Abstract

This paper empirically examines whether asset’s liquidity can help resolve the known strike-price biases of the Black-Scholes model for different liquidity measures based on trading volume, bid-ask spread and the Amihud’s ILLIQ. Our results indicate that, when the underlying asset or its derivative exhibit lower liquidity, the degree of curvature of the strike-price biases will tend to increase, regardless of the liquidity measures used. Furthermore, inspection of 2R reveals that the stock’s liquidity has an excellent ability in explaining the strike-price biases compared with the option’s liquidity in terms of the liquidity measures based on trading volume and the Amihud’s ILLIQ.

Suggested Citation

  • Shih-Ping Feng, 2011. "The Liquidity Effect In Option Pricing: An Empirical Analysis," The International Journal of Business and Finance Research, The Institute for Business and Finance Research, vol. 5(2), pages 35-43.
    • Handle: RePEc:ibf:ijbfre:v:5:y:2011:i:2:p:35-43
    as

    Download full text from publisher

    File URL: http://www.theibfr2.com/RePEc/ibf/ijbfre/ijbfr-v5n2-2011/IJBFR-V5N2-2011-3.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Acharya, Viral V. & Pedersen, Lasse Heje, 2005. "Asset pricing with liquidity risk," Journal of Financial Economics, Elsevier, vol. 77(2), pages 375-410, August.
    2. Menachem Brenner & Rafi Eldor & Shmuel Hauser, 2001. "The Price of Options Illiquidity," Journal of Finance, American Finance Association, vol. 56(2), pages 789-805, April.
    3. Aitken, Michael & Comerton-Forde, Carole, 2003. "How should liquidity be measured?," Pacific-Basin Finance Journal, Elsevier, vol. 11(1), pages 45-59, January.
    4. Bakshi, Gurdip & Cao, Charles & Chen, Zhiwu, 1997. "Empirical Performance of Alternative Option Pricing Models," Journal of Finance, American Finance Association, vol. 52(5), pages 2003-2049, December.
    5. Cao, Melanie & Wei, Jason, 2010. "Option market liquidity: Commonality and other characteristics," Journal of Financial Markets, Elsevier, vol. 13(1), pages 20-48, February.
    6. U. Çetin & R. Jarrow & P. Protter & M. Warachka, 2008. "Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 9, pages 185-221, World Scientific Publishing Co. Pte. Ltd..
    7. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-343.
    8. Amihud, Yakov & Mendelson, Haim, 1986. "Asset pricing and the bid-ask spread," Journal of Financial Economics, Elsevier, vol. 17(2), pages 223-249, December.
    9. Heston, Steven L & Nandi, Saikat, 2000. "A Closed-Form GARCH Option Valuation Model," Review of Financial Studies, Society for Financial Studies, vol. 13(3), pages 585-625.
    10. Amihud, Yakov, 2002. "Illiquidity and stock returns: cross-section and time-series effects," Journal of Financial Markets, Elsevier, vol. 5(1), pages 31-56, January.
    11. Bjørn Eraker, 2004. "Do Stock Prices and Volatility Jump? Reconciling Evidence from Spot and Option Prices," Journal of Finance, American Finance Association, vol. 59(3), pages 1367-1404, June.
    12. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-654, May-June.
    13. Liu, Hong & Yong, Jiongmin, 2005. "Option pricing with an illiquid underlying asset market," Journal of Economic Dynamics and Control, Elsevier, vol. 29(12), pages 2125-2156, December.
    14. MacBeth, James D & Merville, Larry J, 1979. "An Empirical Examination of the Black-Scholes Call Option Pricing Model," Journal of Finance, American Finance Association, vol. 34(5), pages 1173-1186, December.
    15. Datar, Vinay T. & Y. Naik, Narayan & Radcliffe, Robert, 1998. "Liquidity and stock returns: An alternative test," Journal of Financial Markets, Elsevier, vol. 1(2), pages 203-219, August.
    16. Pena, Ignacio & Rubio, Gonzalo & Serna, Gregorio, 1999. "Why do we smile? On the determinants of the implied volatility function," Journal of Banking & Finance, Elsevier, vol. 23(8), pages 1151-1179, August.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Feng, Shih-Ping & Hung, Mao-Wei & Wang, Yaw-Huei, 2016. "The importance of stock liquidity on option pricing," International Review of Economics & Finance, Elsevier, vol. 43(C), pages 457-467.
    2. Li, Zhe & Zhang, Wei-Guo & Liu, Yong-Jun, 2018. "European quanto option pricing in presence of liquidity risk," The North American Journal of Economics and Finance, Elsevier, vol. 45(C), pages 230-244.
    3. Feng, Shih-Ping & Hung, Mao-Wei & Wang, Yaw-Huei, 2014. "Option pricing with stochastic liquidity risk: Theory and evidence," Journal of Financial Markets, Elsevier, vol. 18(C), pages 77-95.
    4. Li, Zhe & Zhang, Wei-Guo & Liu, Yong-Jun & Zhang, Yue, 2019. "Pricing discrete barrier options under jump-diffusion model with liquidity risk," International Review of Economics & Finance, Elsevier, vol. 59(C), pages 347-368.
    5. Peter Christoffersen & Ruslan Goyenko & Kris Jacobs & Mehdi Karoui, 2018. "Illiquidity Premia in the Equity Options Market," Review of Financial Studies, Society for Financial Studies, vol. 31(3), pages 811-851.
    6. Li, Zhe & Zhang, Wei-Guo & Liu, Yong-Jun, 2018. "Analytical valuation for geometric Asian options in illiquid markets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 507(C), pages 175-191.
    7. Lin, Zih-Ying & Chang, Chuang-Chang & Wang, Yaw-Huei, 2018. "The impacts of asymmetric information and short sales on the illiquidity risk premium in the stock option market," Journal of Banking & Finance, Elsevier, vol. 94(C), pages 152-165.
    8. Rubio Irigoyen, Gonzalo & Ferreira García, María Eva & Gago, Mónica & León, Angel, 2002. "An empirical comparison of the performance of alternative option pricing models," DFAEII Working Papers 1988-088X, University of the Basque Country - Department of Foundations of Economic Analysis II.
    9. Thomas Paul & Thomas Walther & André Küster-Simic, 2022. "Empirical analysis of the illiquidity premia of German real estate securities," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 36(2), pages 203-260, June.
    10. Henri Bertholon & Alain Monfort & Fulvio Pegoraro, 2006. "Pricing and Inference with Mixtures of Conditionally Normal Processes," Working Papers 2006-28, Center for Research in Economics and Statistics.
    11. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    12. Li, Zhe & Zhang, Weiguo & Zhang, Yue & Yi, Zhigao, 2019. "An analytical approximation approach for pricing European options in a two-price economy," The North American Journal of Economics and Finance, Elsevier, vol. 50(C).
    13. Jin Zhang & Yi Xiang, 2008. "The implied volatility smirk," Quantitative Finance, Taylor & Francis Journals, vol. 8(3), pages 263-284.
    14. Choy, Siu Kai & Wei, Jason, 2020. "Liquidity risk and expected option returns," Journal of Banking & Finance, Elsevier, vol. 111(C).
    15. Konstantinos Konstantaras & Vasilios Sogiakas, 2019. "Is stock liquidity transferred and upgraded in acquisitions? Evidence from liquidity synergies in US freeze-outs," Annals of Operations Research, Springer, vol. 282(1), pages 179-216, November.
    16. Hsuan-Chu Lin & Ren-Raw Chen & Oded Palmon, 2016. "Explaining the volatility smile: non-parametric versus parametric option models," Review of Quantitative Finance and Accounting, Springer, vol. 46(4), pages 907-935, May.
    17. Gang Li & Chu Zhang, 2010. "On the Number of State Variables in Options Pricing," Management Science, INFORMS, vol. 56(11), pages 2058-2075, November.
    18. Vayanos, Dimitri & Wang, Jiang, 2013. "Market Liquidity—Theory and Empirical Evidence ," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, volume 2, chapter 0, pages 1289-1361, Elsevier.
    19. Rombouts, Jeroen V.K. & Stentoft, Lars, 2015. "Option pricing with asymmetric heteroskedastic normal mixture models," International Journal of Forecasting, Elsevier, vol. 31(3), pages 635-650.
    20. Gonçalo Faria & João Correia-da-Silva, 2014. "A closed-form solution for options with ambiguity about stochastic volatility," Review of Derivatives Research, Springer, vol. 17(2), pages 125-159, July.

    More about this item

    Keywords

    Option Pricing; Liquidity; Stock’s Liquidity; Option’s Liquidity; Strike-Price Biases;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ibf:ijbfre:v:5:y:2011:i:2:p:35-43. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Mercedes Jalbert (email available below). General contact details of provider: .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.