Illiquidity Premia in the Equity Options Market
University of Toronto - Rotman School of Management; Copenhagen Business School; University of Aarhus - CREATES
McGill University - Desautels Faculty of Management
University of Houston - C.T. Bauer College of Business
July 4, 2014
Illiquidity is well-known to be a significant determinant of stock and bond returns. We are the first to estimate illiquidity premia in equity option markets using effective spreads for a large cross-section of firms. The risk-adjusted return spread for illiquid over liquid options is 23 bps per day for calls. The spread for puts is somewhat lower but still significant at 13 bps per day. The spread is generally largest for out-of-the money options. The illiquidity premium is robust to different empirical implementations. It is also robust when controlling for various firm-specific variables, including standard measures of illiquidity of the underlying stock, determinants of spreads, and a measure of net demand pressure. The positive illiquidity premium we find is consistent with existing evidence that market makers in the equity options market hold net long positions.
Number of Pages in PDF File: 59
Keywords: illiquidity, equity options, cross-section, option returns, option smile
JEL Classification: G12
Date posted: March 15, 2011 ; Last revised: July 5, 2014
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