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
March 15, 2012
Illiquidity is well-known to be a significant determinant of stock and bond returns. We report on illiquidity premia in the equity options market. An increase in option illiquidity decreases the current option price and implies higher expected option returns. This effect is statistically and economically signifi cant. It is robust across different empirical approaches and when including various control variables. The illiquidity of the underlying stock affects the option return negatively, consistent with a hedging argument: When stock market illiquidity increases, the cost of replicating the option goes up, which increases the option price and reduces its expected return.
Number of Pages in PDF File: 47
Keywords: illiquidity, equity options, cross-section, option returns, option smile
JEL Classification: G12working papers series
Date posted: March 15, 2011 ; Last revised: March 16, 2012
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