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The importance of stock liquidity on option pricing

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

Abstract

This paper examines the impact of stock liquidity on option pricing by comparing pricing performance across two option pricing models. These two models are identical in all respects except for the presence of illiquidity in the underlying asset. Using various liquidity measures, the empirical results reveal a clear link between stock liquidity and option pricing. Specifically, adding a stock liquidity adjustment into an option pricing model produces smaller and more stable pricing errors for all comparison groups. The improvement rate is particularly high for options on stocks with lower liquidity and for out-of-the-money options. Our results are robust across liquidity measures and evaluation criteria. These findings highlight the significance of accounting for the stock liquidity when pricing options.

Suggested Citation

  • Feng, Shih-Ping & Hung, Mao-Wei & Wang, Yaw-Huei, 2016. "The importance of stock liquidity on option pricing," International Review of Economics & Finance, Elsevier, vol. 43(C), pages 457-467.
    • Handle: RePEc:eee:reveco:v:43:y:2016:i:c:p:457-467
    DOI: 10.1016/j.iref.2016.01.008
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    Cited by:

    1. Ripamonti, Alexandre & Silva, Diego & Moreira Neto, Eurico, 2018. "Asset Pricing and Asymmetric Information," MPRA Paper 87403, University Library of Munich, Germany.
    2. Gao, Rui & Li, Yaqiong & Lin, Lisha, 2019. "Bayesian statistical inference for European options with stock liquidity," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 518(C), pages 312-322.
    3. Li, Zhe & Zhang, Wei-Guo & Liu, Yong-Jun & Zhang, Yue, 2019. "Pricing discrete barrier options under jump-diffusion model with liquidity risk," International Review of Economics & Finance, Elsevier, vol. 59(C), pages 347-368.
    4. Xingchun Wang, 2021. "Pricing vulnerable options with jump risk and liquidity risk," Review of Derivatives Research, Springer, vol. 24(3), pages 243-260, October.
    5. Lu, Jin-Ray & Yang, Ya-Huei, 2021. "Option valuations and asset demands and supplies," The Quarterly Review of Economics and Finance, Elsevier, vol. 80(C), pages 49-64.
    6. (Meni) Abudy, Menachem & Binsky, Hadar & Raviv, Alon, 2018. "The effect of liquidity on non-marketable securities," Finance Research Letters, Elsevier, vol. 26(C), pages 139-144.
    7. Chuang, Ming-Che & Tsai, Jeffrey Tzuhao, 2024. "Determining bid-ask prices for options with stochastic illiquidity and applications to index options," Pacific-Basin Finance Journal, Elsevier, vol. 84(C).
    8. Li, Zhe & Zhang, Weiguo & Zhang, Yue & Yi, Zhigao, 2019. "An analytical approximation approach for pricing European options in a two-price economy," The North American Journal of Economics and Finance, Elsevier, vol. 50(C).
    9. Cai, Chengyou & Wang, Xingchun & Yu, Baimin, 2024. "Pricing vulnerable spread options with liquidity risk under Lévy processes," The North American Journal of Economics and Finance, Elsevier, vol. 72(C).
    10. Li, Zhe & Zhang, Wei-Guo & Liu, Yong-Jun, 2018. "Analytical valuation for geometric Asian options in illiquid markets," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 507(C), pages 175-191.
    11. Wang, Xingchun, 2022. "Pricing vulnerable options with stochastic liquidity risk," The North American Journal of Economics and Finance, Elsevier, vol. 60(C).
    12. Xu, De-xuan & Yang, Ben-zhang & Kang, Jian-hao & Huang, Nan-jing, 2021. "Variance and volatility swaps valuations with the stochastic liquidity risk," Physica A: Statistical Mechanics and its Applications, Elsevier, vol. 566(C).
    13. Li, Zhe & Zhang, Wei-Guo & Liu, Yong-Jun, 2018. "European quanto option pricing in presence of liquidity risk," The North American Journal of Economics and Finance, Elsevier, vol. 45(C), pages 230-244.

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    More about this item

    Keywords

    Stock liquidity; Liquidity measures; Option pricing;
    All these keywords.

    JEL classification:

    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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