A Risk-Neutral Parametric Liquidity Model for Derivatives

David Bakstein and Sam Howison

OFRC Working Papers Series from Oxford Financial Research Centre

Abstract: We develop a parameterised model for liquidity effects arising from the trading in an asset. Liquidity is defined via a combination of a trader's individual transaction cost and a price slippage impact, which is felt by all market participants. The chosen definition allows liquidity to be observable in a centralised order-book of an asset as is usually provided in most non-specialist exchanges. The discrete-time version of the model is based on the CRR binomial tree and in the appropriate continuous-time limits we derive various nonlinear partial differential equations. Both versions can be directly applied to the pricing and hedging of options; the nonlinear nature of liquidity leads to natural bid-ask spreads that are based on the liquidity of the market for the underlying and the existence of (super-)replication strategies. We test and calibrate our model empirically with high-frequency data of German blue chips and discuss further extensions to the model, including stochastic liquidity.

Date: 2002
New Economics Papers: this item is included in nep-fin, nep-fmk and nep-rmg
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