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Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence

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  • U. Çetin
  • R. Jarrow
  • P. Protter
  • M. Warachka

Abstract

This article studies the pricing of options in an extended Black Scholes economy in which the underlying asset is not perfectly liquid. The resulting liquidity risk is modeled as a stochastic supply curve, with the transaction price being a function of the trade size. Consistent with the market microstructure literature, the supply curve is upward sloping with purchases executed at higher prices and sales at lower prices. Optimal discrete time hedging strategies are then derived. Empirical evidence reveals a significant liquidity cost intrinsic to every option. Copyright 2006, Oxford University Press.

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  • U. Çetin & R. Jarrow & P. Protter & M. Warachka, 2006. "Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence," The Review of Financial Studies, Society for Financial Studies, vol. 19(2), pages 493-529.
    • Handle: RePEc:oup:rfinst:v:19:y:2006:i:2:p:493-529
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    More about this item

    JEL classification:

    • B26 - Schools of Economic Thought and Methodology - - History of Economic Thought since 1925 - - - Financial Economics
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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