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Option pricing with stochastic liquidity risk: Theory and evidence

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  • Feng, Shih-Ping
  • Hung, Mao-Wei
  • Wang, Yaw-Huei

Abstract

This study develops a liquidity-adjusted option pricing model that demonstrates the impact of the liquidity risk on stock prices using a liquidity discount factor. The discount factor relates to both mean-reversion stochastic market liquidity and the sensitivity of stock prices to market illiquidity. Our empirical results provide strong evidence in support of incorporating liquidity risk in options pricing. In particular, our model shows marked pricing improvement for out-of-the-money or longer term options, as well as options on stocks with lower levels of liquidity.

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  • Feng, Shih-Ping & Hung, Mao-Wei & Wang, Yaw-Huei, 2014. "Option pricing with stochastic liquidity risk: Theory and evidence," Journal of Financial Markets, Elsevier, vol. 18(C), pages 77-95.
    • Handle: RePEc:eee:finmar:v:18:y:2014:i:c:p:77-95
    DOI: 10.1016/j.finmar.2013.05.002
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    Cited by:

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    8. Ziming Dong & Dan Tang & Xingchun Wang, 2023. "Pricing vulnerable basket spread options with liquidity risk," Review of Derivatives Research, Springer, vol. 26(1), pages 23-50, April.
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    10. Puneet Pasricha & Song-Ping Zhu & Xin-Jiang He, 2022. "A closed-form pricing formula for European options in an illiquid asset market," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 8(1), pages 1-18, December.
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    16. Xin‐Jiang He & Sha Lin, 2023. "Analytically pricing exchange options with stochastic liquidity and regime switching," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 43(5), pages 662-676, May.
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    More about this item

    Keywords

    Option pricing; Liquidity risk; Liquidity discount factor;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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