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A closed-form pricing formula for European options in an illiquid asset market

Author

Listed:
  • Puneet Pasricha

    (University of Wollongong)

  • Song-Ping Zhu

    (University of Wollongong)

  • Xin-Jiang He

    (Zhejiang University of Technology)

Abstract

This article addresses the problem of pricing European options when the underlying asset is not perfectly liquid. A liquidity discounting factor as a function of market-wide liquidity governed by a mean-reverting stochastic process and the sensitivity of the underlying price to market-wide liquidity is firstly introduced, so that the impact of liquidity on the underlying asset can be captured by the option pricing model. The characteristic function is analytically worked out using the Feynman–Kac theorem and a closed-form pricing formula for European options is successfully derived thereafter. Through numerical experiments, the accuracy of the newly derived formula is verified, and the significance of incorporating liquidity risk into option pricing is demonstrated.

Suggested Citation

  • Puneet Pasricha & Song-Ping Zhu & Xin-Jiang He, 2022. "A closed-form pricing formula for European options in an illiquid asset market," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 8(1), pages 1-18, December.
    • Handle: RePEc:spr:fininn:v:8:y:2022:i:1:d:10.1186_s40854-022-00337-6
    DOI: 10.1186/s40854-022-00337-6
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    References listed on IDEAS

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    Cited by:

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    3. Jenny Jing Wang & Jianfu Shen & Frederik Pretorius, 2023. "Valuing options to renew at future market value: the case of commercial property leases," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 9(1), pages 1-35, December.
    4. Cai, Chengyou & Wang, Xingchun & Yu, Baimin, 2024. "Pricing vulnerable spread options with liquidity risk under Lévy processes," The North American Journal of Economics and Finance, Elsevier, vol. 72(C).

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