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A note on fair value and illiquid markets

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Abstract

We present in this paper a method to extract fair prices from observable prices in an illiquid market. The dynamics of fair prices have a general form encompassing random walks. In fact, only a part of a movement in price is assumed to reflect fundamental changes, the rest is considered to be friction. That part is optimally estimated by a Kalman filter". The model allows also to recover liquidity premia as a product of innovations times an illiquidity multiplier. Thus the higher the difference between observed and filtered prices (prices obtained under "normal" market dynamics), the higher liquidity premium will be. The model can be adapted to various kind of instruments and calibrated in different ways

Suggested Citation

  • Dominique Guegan & Chafic Merhy, 2010. "A note on fair value and illiquid markets," Documents de travail du Centre d'Economie de la Sorbonne 10001, Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne.
    • Handle: RePEc:mse:cesdoc:10001
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    Keywords

    Fair value; illiquid market; Kalman filter; Mark to model;
    All these keywords.

    JEL classification:

    • C1 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)

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