Determining bid-ask prices for options with stochastic illiquidity and applications to index options

Ming-Che Chuang and Jeffrey Tzuhao Tsai

Pacific-Basin Finance Journal, 2024, vol. 84, issue C

Abstract: Market makers must quote two prices - bid and ask prices - for options. This article provides a GARCH model with stochastic illiquidity risks and gives analytical approximation solutions for the bid and ask prices for options. A joint calibration method is applied for calibrating the implied parameters. The empirical evidence shows an illiquidity smile for short-term calls and a negatively sloped illiquidity smirk for long-term calls. Similar results are also observed in put option prices. The proposed stochastic illiquidity model significantly outperforms the static illiquidity model in the in-sample and out-of-sample tests, particularly when the stochastic volatility is crucial.

Keywords: Stochastic illiquidity; Illiquidity smile; Illiquidity smirk; Joint calibration; Coherent risk measure; Fourier cosine series expansion (search for similar items in EconPapers)
JEL-codes: C22 C46 G12 G13 (search for similar items in EconPapers)
Date: 2024
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0927538X24000659
Full text for ScienceDirect subscribers only

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:pacfin:v:84:y:2024:i:c:s0927538x24000659

DOI: 10.1016/j.pacfin.2024.102314

Access Statistics for this article

Pacific-Basin Finance Journal is currently edited by K. Chan and S. Ghon Rhee

More articles in Pacific-Basin Finance Journal from Elsevier
Bibliographic data for series maintained by Catherine Liu ().