The Impact of Liquidity on Option Prices

Journal of Futures Markets 31(12):1116-1141.

42 Pages Posted: 17 Mar 2010 Last revised: 23 Feb 2019

See all articles by Robin K. Chou

Robin K. Chou

National Chengchi University

Yu-Jen Hsiao

National Central University

Yaw-Huei Wang

National Taiwan University; UNSW

San-Lin Chung

National Taiwan University - Department of Finance

Date Written: March 15, 2010

Abstract

This article 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), whilst 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, thereby echoing the recent findings of Garleanu, Pedersen and Poteshman (2009) who find that the net demand for equity options by end users across different levels of moneyness is related to their cost.

Keywords: Liquidity, Option price, Implied volatility curve, Hedging cost

JEL Classification: G12, G13

Suggested Citation

Chou, Robin K. and Hsiao, Yu-Jen and Wang, Yaw-Huei and Chung, San-Lin, The Impact of Liquidity on Option Prices (March 15, 2010). Journal of Futures Markets 31(12):1116-1141., Available at SSRN: https://ssrn.com/abstract=1571515 or http://dx.doi.org/10.2139/ssrn.1571515

Robin K. Chou

National Chengchi University ( email )

No. 64, Chih-Nan Road
Section 2
Wenshan, Taipei, 11623
Taiwan
+886-2-29393091 ext. 81016 (Phone)

Yu-Jen Hsiao

National Central University ( email )

No. 300, Zhongda Road
Chung-Li Taiwan, 32054
Taiwan

Yaw-Huei Wang

National Taiwan University ( email )

Department and Graduate Institute of Finance
College of Management
Taipei, 106
Taiwan
+886233661092 (Phone)
+886283695581 (Fax)

UNSW ( email )

Sydney, NSW 2052
Australia

San-Lin Chung (Contact Author)

National Taiwan University - Department of Finance ( email )

Taipei, 106
Taiwan
886-2-33661084 (Phone)
886-2-23660764 (Fax)

HOME PAGE: http://www.fin.ntu.edu.tw/~slchung/

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