Market Illiquidity and the Bid-Ask Spread of Derivatives
FEUNL Working Paper Series, No. 386
39 Pages Posted: 31 Jan 2006
Date Written: 2000
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.
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