Market Illiquidity and the Bid-Ask Spread of Derivatives

FEUNL Working Paper Series, No. 386

39 Pages Posted: 31 Jan 2006

See all articles by Joao Amaro de Matos

Joao Amaro de Matos

Nova School of Business and Economics

Paula Antão

Bank of Portugal - Department of Economics

Date Written: 2000

Abstract

This paper analyzes the impact of illiquidity of a stock on the pricing of derivatives. In particular, it is shown how illiquidity generates a bid-ask spread in an option on this stock, even in the absence of other imperfections, such as transaction costs and asymmetry of information. Moreover, the spread is shown to be asymmetric with respect to the option price under perfect liquidity. This fact explains the appearance of a smile e¤ect when the implied volatility is estimated from the mid-quote.

Suggested Citation

Amaro de Matos, Joao and Antão, Paula, Market Illiquidity and the Bid-Ask Spread of Derivatives (2000). Available at SSRN: https://ssrn.com/abstract=879754 or http://dx.doi.org/10.2139/ssrn.879754

Joao Amaro de Matos (Contact Author)

Nova School of Business and Economics ( email )

Campus de Campolide
Lisbon, 1099-038
Portugal

HOME PAGE: http://docentes.fe.unl.pt/~amatos

Paula Antão

Bank of Portugal - Department of Economics ( email )

Av Almirante Reis, 71
P-1150-012 Lisboa
Portugal

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