Discrete-time option pricing with stochastic liquidity

Markus Leippold () and Steven Schärer

Journal of Banking & Finance, 2017, vol. 75, issue C, 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.

Keywords: Market liquidity; Bid-Ask spreads; Option pricing; Stochastic liquidity; Conic finance (search for similar items in EconPapers)
JEL-codes: C51 D52 G12 G13 (search for similar items in EconPapers)
Date: 2017
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (14)

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Related works:
Working Paper: Discrete-Time Option Pricing with Stochastic Liquidity (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jbfina:v:75:y:2017:i:c:p:1-16

DOI: 10.1016/j.jbankfin.2016.11.014

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