Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence

By Umut Çetin, Robert A. Jarrow, Philip Protter, Mitch Warachka. 2006

194 citations recorded by the source corpus.

This article studies the pricing of options in an extended Black Scholes economy in which the underlying asset is not perfectly liquid. The resulting liquidity risk is modeled as a stochastic supply curve, with the transaction price being a function of the trade size. Consistent with the market microstructure literature, the supply curve is upward sloping with purchases executed at higher prices and sales at lower prices. Optimal discrete time hedging strategies are then derived. Empirical evidence reveals a significant liquidity cost intrinsic to every option.

Subfields: Economics and Econometrics, Finance

View Paper: https://www.semanticscholar.org/paper/9af80618c9b6d9b697fcd240ad4601b71c4f78e4

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Citations in the corpus

Interest Rates and The Credit Crunch: New Formulas and Market Models (2009, unknown): “11Liquidity effects are modeled, among others, by Cetin et al. (2006) and Acerbi and Scandolo (2007).”
Bid-Ask Dynamic Pricing in Financial Markets with Transaction Costs and Liquidity Risk (2007, background): “Cetin et al [16] and [17] or Astic and Touzi [3] have developed a pricing approach taking into account the liquidity risk.”
Derivative Pricing with Liquidity Risk: Theory and Evidence from the Credit Default Swap Market (2011, unknown): “Chen et al. (2005) estimate the impact of liquidity and other factors on CDS spreads using a term structure approach. They find that premia for liquidity risk and expected liquidity premium are earned by the CDS buyer. The identification of the liquidity risk premium comes from the term structure of”
OPTION PRICING AND HEDGING WITH EXECUTION COSTS AND MARKET IMPACT (2013, unknown): “In this approach, introduced by Çetin, Jarrow, and Protter (2004) (see also Bank and Baum 2004; Çetin et al. 2006; Çetin and Rogers 2007), traders are not price takers, and the price they pay depends on the quantity they trade.”
DYNAMIC TRADING VOLUME (2012, unknown): “Our paper also differs from the approaches of Cetin, Jarrow, and Protter (2004); Cetin et al. (2006); Cetin, Soner, and Touzi (2010), who specify price impact functions proportional to trading quantities, rather than rates, but find that in continuous time price impact disappears with smooth…”
Illiquidity Premia in the Equity Options Market (2018, background): “22 Finally, the expected sign for the effect of stock illiquidity on expected option returns can be motivated by the discussion in Cetin et al (2006).”