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Liquidity considerations in estimating implied volatility

Author

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  • Rohini Grover

    (Indira Gandhi Institute of Development Research)

  • Susan Thomas

    () (Indira Gandhi Institute of Development Research)

Abstract

Some option series in the market are far less liquid than others. Market illiquidity can reduce the informativeness of option prices. In this paper, we propose alternative schemes to estimate implied volatility while reducing the importance attached to illiquid options. Using data for index options traded at the National Stock Exchange in India, we and that the performance of a liquidity weighted scheme is superior to that of more conventional schemes such as the vega weights, the volatility elasticity weights and the traditional vxo. Liquidity weights offers the possibility of improved implied volatility estimation in situations where there is strong cross-sectional variation in option market liquidity.

Suggested Citation

  • Rohini Grover & Susan Thomas, 2011. "Liquidity considerations in estimating implied volatility," Indira Gandhi Institute of Development Research, Mumbai Working Papers 2011-006, Indira Gandhi Institute of Development Research, Mumbai, India.
  • Handle: RePEc:ind:igiwpp:2011-006
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    File URL: http://www.igidr.ac.in/pdf/publication/WP-2011-006.pdf
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    References listed on IDEAS

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    1. Menachem Brenner, 2001. "The Price of Options Illiquidity," Journal of Finance, American Finance Association, vol. 56(2), pages 789-805, April.
    2. Becker, Ralf & Clements, Adam E., 2008. "Are combination forecasts of S&P 500 volatility statistically superior?," International Journal of Forecasting, Elsevier, vol. 24(1), pages 122-133.
    3. 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..
    4. Jackwerth, Jens Carsten & Rubinstein, Mark, 1996. " Recovering Probability Distributions from Option Prices," Journal of Finance, American Finance Association, vol. 51(5), pages 1611-1632, December.
    5. Peter Reinhard Hansen & Asger Lunde & James M. Nason, 2003. "Choosing the Best Volatility Models: The Model Confidence Set Approach," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 65(s1), pages 839-861, December.
    6. Heynen, Ronald & Kemna, Angelien & Vorst, Ton, 1994. "Analysis of the Term Structure of Implied Volatilities," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 29(01), pages 31-56, March.
    7. Blair, Bevan J. & Poon, Ser-Huang & Taylor, Stephen J., 2001. "Forecasting S&P 100 volatility: the incremental information content of implied volatilities and high-frequency index returns," Journal of Econometrics, Elsevier, vol. 105(1), pages 5-26, November.
    8. Christensen, B. J. & Prabhala, N. R., 1998. "The relation between implied and realized volatility," Journal of Financial Economics, Elsevier, vol. 50(2), pages 125-150, November.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. The rupee: Frequently asked questions
      by Ajay Shah in Ajay Shah's blog on 2011-12-02 00:26:00
    2. Interesting readings
      by Ajay Shah in Ajay Shah's blog on 2011-05-20 09:33:00
    3. New insights into the events on the Indian stock market in the mid-1990s
      by Ajay Shah in Ajay Shah's blog on 2012-04-11 22:22:00
    4. New insights into the events on the Indian stock market in the mid-1990s
      by Ajay Shah in Citizen Economists on 2012-04-14 00:10:04
    5. The rupee: Frequently asked questions
      by Ajay Shah in Citizen Economists on 2011-12-02 20:50:18
    6. Interesting Readings for May 20, 2011
      by Ajay Shah in Citizen Economists on 2011-05-20 22:20:24

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    1. repec:spr:jqecon:v:16:y:2018:i:1:d:10.1007_s40953-017-0078-3 is not listed on IDEAS
    2. Rohini Grover & Ajay Shah, 2014. "The imprecision of volatility indexes," Indira Gandhi Institute of Development Research, Mumbai Working Papers 2014-031, Indira Gandhi Institute of Development Research, Mumbai, India.
    3. Chaiyuth Padungsaksawasdi & Robert T. Daigler, 2014. "The Return‐Implied Volatility Relation for Commodity ETFs," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 34(3), pages 261-281, March.

    More about this item

    Keywords

    liquidity; implied volatility; volatility index; Indian index options market;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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