Market illiquidity and bounds on European option prices
The paper analyses the impact of illiquidity of a stock paying no dividends on the pricing of European options written on that stock. In particular, it is shown how illiquidity generates price bounds on an option on this stock, even in the absence of other imperfections, such as transaction costs and trading constraints, or the assumption of stochastic volatility. Moreover, price bounds are shown to be asymmetric with respect to the option price under perfect liquidity. This fact explains, under some conditions, the appearance of a smile effect when the implied volatility is estimated from the mid-quote.
Volume (Year): 9 (2003)
Issue (Month): 5 ()
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- Engle, Robert F, 1999.
"Modeling the Impacts of Market Activity on Bid-Ask Spreads in the Option Market,"
University of California at San Diego, Economics Working Paper Series
qt6rp7g17q, Department of Economics, UC San Diego.
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