The importance of stock liquidity on option pricing

Shih-Ping Feng, Mao-Wei Hung and Yaw-Huei Wang

International Review of Economics & Finance, 2016, vol. 43, issue C, 457-467

Abstract: This paper examines the impact of stock liquidity on option pricing by comparing pricing performance across two option pricing models. These two models are identical in all respects except for the presence of illiquidity in the underlying asset. Using various liquidity measures, the empirical results reveal a clear link between stock liquidity and option pricing. Specifically, adding a stock liquidity adjustment into an option pricing model produces smaller and more stable pricing errors for all comparison groups. The improvement rate is particularly high for options on stocks with lower liquidity and for out-of-the-money options. Our results are robust across liquidity measures and evaluation criteria. These findings highlight the significance of accounting for the stock liquidity when pricing options.

Keywords: Stock liquidity; Liquidity measures; Option pricing (search for similar items in EconPapers)
JEL-codes: G10 G13 (search for similar items in EconPapers)
Date: 2016
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Citations: View citations in EconPapers (16)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:43:y:2016:i:c:p:457-467

DOI: 10.1016/j.iref.2016.01.008

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