The Impact of Liquidity on Option Prices

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