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

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Author Info
U. Çetin
R. Jarrow
P. Protter
M. Warachka

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Abstract

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. Copyright 2006, Oxford University Press.

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File URL: http://hdl.handle.net/10.1093/rfs/hhj014
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Publisher Info
Article provided by Oxford University Press for Society for Financial Studies in its journal The Review of Financial Studies.

Volume (Year): 19 (2006)
Issue (Month): 2 ()
Pages: 493-529
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Handle: RePEc:oup:rfinst:v:19:y:2006:i:2:p:493-529

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  1. Frank Milne, 2008. "Credit Crises, Risk Management Systems and Liquidity Modelling," Working Papers 1, John Deutsch Institute for the Study of Economic Policy. [Downloadable!]
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This page was last updated on 2009-10-23.

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