The Pricing of Derivatives in Illiquid Markets
This paper develops a parametric model for liquidity effects due to trading. The liquidity parameterisation is defined to consist of a transaction cost effect and a price slippage effect, the latter felt by all participants in the market. The model is based on the CRR binomial trees and is applied to the pricing and hedging of options. It can be used to derive natural bid-ask spreads for an option given the liquidity in the underlying. The paper also mentions further applications to portfolio trading, liquidity options and strike detection.
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