Illiquidity and Higher Cumulants
Review of Financial Studies, Forthcoming
76 Pages Posted: 15 Sep 2020 Last revised: 16 Aug 2022
Date Written: August 13, 2022
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