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How Does Duration Between Trades of Underlying Securities Affect Option Prices

Author

Listed:
  • Alvaro Cartea

    (Department of Economics, Mathematics & Statistics, Birkbeck)

  • Thilo Meyer-Brandis

Abstract

We propose a model for stock price dynamics that explicitly incorporates random waiting times between trades, also known as duration, and show how option prices can be calculated using this model. We use ultra-high-frequency data for blue-chip companies to motivate a particular choice of waiting-time distribution and then calibrate risk-neutral parameters from options data. We also show that the convexity commonly observed in implied volatilities may be explained by the presence of duration between trades. Furthermore, we find that, ceteris paribus, implied volatility decreases in the presence of longer durations, a result consistent with the findings of Engle (2000) and Dufour and Engle (2000) which demonstrates the relationship between levels of activity and volatility for stock prices.

Suggested Citation

  • Alvaro Cartea & Thilo Meyer-Brandis, 2007. "How Does Duration Between Trades of Underlying Securities Affect Option Prices," Birkbeck Working Papers in Economics and Finance 0721, Birkbeck, Department of Economics, Mathematics & Statistics.
    • Handle: RePEc:bbk:bbkefp:0721
    as

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    File URL: https://eprints.bbk.ac.uk/id/eprint/26867
    File Function: First version, 2007
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    References listed on IDEAS

    as
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    Keywords

    Duration between trades; waiting-times; high frequency data; Levy processes; option pricing; time changes; operational time; irregularly spaced data.;
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