Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence
Publication Type
Journal Article
Version
acceptedVersion
Publication Date
6-2010
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. [PUBLICATION ABSTRACT]
Keywords
Option Pricing, Liquidity, Black Scholes
Discipline
Finance and Financial Management | Portfolio and Security Analysis
Research Areas
Finance
Publication
Review of Financial Studies
Volume
19
Issue
2
First Page
493
Last Page
529
ISSN
0893-9454
Identifier
10.1093/rfs/hhj014
Publisher
Oxford University Press
Citation
Cetin, Umut; Jarrow, Robert; Protter, Mitchell; and WARACHKA, Mitchell.
Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence. (2010). Review of Financial Studies. 19, (2), 493-529.
Available at: https://ink.library.smu.edu.sg/lkcsb_research/2787
Copyright Owner and License
Authors
Creative Commons License
This work is licensed under a Creative Commons Attribution-NonCommercial-No Derivative Works 4.0 International License.
Additional URL
https://doi.org/10.1093/rfs/hhj014