The impact of liquidity on option prices

Robin K. Chou, San Lin Chung, Yu Jen Hsiao, Yaw Huei Wang

Research output: Contribution to journalArticlepeer-review

14 Citations (Scopus)

Abstract

This study illustrates the impact of both spot and option liquidity levels on option prices. Using implied volatility to measure the option price structure, our empirical results reveal that even after controlling for the systematic risk of Duan and Wei (2009), a clear link remains between option prices and liquidity; with a reduction (increase) in spot (option) liquidity, there is a corresponding increase in the level of the implied volatility curve. The former is consistent with the explanation on hedging costs provided by Cetin, Jarrow, Protter, and Warachka (2006), whereas the latter is consistent with the "illiquidity premium" hypothesis of Amihud and Mendelson (1986a). This study also shows that the slope of the implied volatility curve can be partially explained by option liquidity.

Original languageEnglish
Pages (from-to)1116-1141
Number of pages26
JournalJournal of Futures Markets
Volume31
Issue number12
DOIs
Publication statusPublished - Dec 1 2011
Externally publishedYes

ASJC Scopus subject areas

  • Accounting
  • Business, Management and Accounting(all)
  • Finance
  • Economics and Econometrics

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