Illiquidity and Higher Cumulants

We characterize the unique equilibrium in an economy populated by strategic CARA investors who trade multiple risky assets with arbitrarily distributed payoffs. We use our explicit solution to study the joint behavior of illiquidity of option contracts. Option bid-ask spreads are proportional to risk aversion and risk-neutral variances of option payoffs. Contrary to the conventional wisdom, spreads may decrease in risk aversion, physical variance, open interest, and increase after earnings announcements. All these predictions are confirmed empirically using a large panel dataset of US stock options.

Keywords: Price Impact, Higher Cumulants, Strategic Trading, Liquidity

JEL Classification: D21, G31, G32, G35, L11

Suggested Citation: Suggested Citation

Glebkin, Sergei and Malamud, Semyon and Teguia, Alberto, Illiquidity and Higher Cumulants (August 13, 2022). Swiss Finance Institute Research Paper No. 20-80, Review of Financial Studies, Forthcoming, Available at SSRN: https://ssrn.com/abstract=3692589 or http://dx.doi.org/10.2139/ssrn.3692589