Liquidity Risk and Expected Option Returns

44 Pages Posted: 13 Jan 2016

See all articles by Siu Kai Choy

Siu Kai Choy

King's College London

Jason Zhanshun Wei

University of Toronto - Rotman School of Management

Date Written: January 4, 2016

Abstract

Using data from OptionMetrics for the period of 1996 to 2013, we establish the existence of liquidity risk premium in option returns via both sorting analyses and Fama-MacBeth regressions. In leverage-adjusted, hedged returns, the alpha due to liquidity risk ranges from 11.2 basis points to 19.7 basis points per month. In hedged returns unadjusted for leverage, the alpha ranges from 88.8 basis points to 254 basis points per month. In contrast to the findings for stocks and bonds, the liquidity risk premium uncovered in option returns is negative. The negative premium is due to the fact that end-users of options write options in net and they care more about liquidity risk than market makers. Our results are robust to alternative data screening criteria and liquidity measure/factor constructions.

Keywords: Liquidity risk, liquidity risk premium, option returns

JEL Classification: G14

Suggested Citation

Choy, Siu Kai and Wei, Jason Zhanshun, Liquidity Risk and Expected Option Returns (January 4, 2016). Rotman School of Management Working Paper No. 2713915, Available at SSRN: https://ssrn.com/abstract=2713915 or http://dx.doi.org/10.2139/ssrn.2713915

Siu Kai Choy

King's College London ( email )

Strand
London, WC2R 2LS
United Kingdom

Jason Zhanshun Wei (Contact Author)

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S 3E6 M5S1S4
Canada
416-978-3698 (Phone)
416-971-3048 (Fax)

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