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Discrete-time option pricing with stochastic liquidity


Leippold, Markus; Schärer, Steven (2017). Discrete-time option pricing with stochastic liquidity. Journal of Banking and Finance, 75:1-16.

Abstract

Classical option pricing theories are usually built on the law of one price, neglecting the impact of market liquidity that may contribute to significant bid-ask spreads. Within the framework of conic finance, we develop a stochastic liquidity model, extending the discrete-time constant liquidity model of Madan (2010). With this extension, we can replicate the term and skew structures of bid-ask spreads typically observed in option markets. We show how to implement such a stochastic liquidity model within our framework using multidimensional binomial trees and we calibrate it to call and put options on the S&P 500.

Abstract

Classical option pricing theories are usually built on the law of one price, neglecting the impact of market liquidity that may contribute to significant bid-ask spreads. Within the framework of conic finance, we develop a stochastic liquidity model, extending the discrete-time constant liquidity model of Madan (2010). With this extension, we can replicate the term and skew structures of bid-ask spreads typically observed in option markets. We show how to implement such a stochastic liquidity model within our framework using multidimensional binomial trees and we calibrate it to call and put options on the S&P 500.

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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:February 2017
Deposited On:09 Dec 2016 10:34
Last Modified:31 Jan 2017 08:33
Publisher:Elsevier
ISSN:0378-4266
Additional Information:Market liquidity; Bid-Ask spreads; Option pricing; Stochastic liquidity; Conic finance
Publisher DOI:https://doi.org/10.1016/j.jbankfin.2016.11.014
Related URLs:http://www.sciencedirect.com/science/article/pii/S0378426616302199 (Publisher)
Other Identification Number:merlin-id:14014

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Embargo till: 2019-11-16