How Does Duration Between Trades of Underlying Securities Affect Option Prices

Álvaro Cartea () and Thilo Meyer-Brandis

No 721, Birkbeck Working Papers in Economics and Finance from Birkbeck, Department of Economics, Mathematics & Statistics

Abstract: We propose a model for stock price dynamics that explicitly incorporates random waiting times between trades, also known as duration, and show how option prices can be calculated using this model. We use ultra-high-frequency data for blue-chip companies to motivate a particular choice of waiting-time distribution and then calibrate risk-neutral parameters from options data. We also show that the convexity commonly observed in implied volatilities may be explained by the presence of duration between trades. Furthermore, we find that, ceteris paribus, implied volatility decreases in the presence of longer durations, a result consistent with the findings of Engle (2000) and Dufour and Engle (2000) which demonstrates the relationship between levels of activity and volatility for stock prices.

Keywords: Duration between trades; waiting-times; high frequency data; Levy processes; option pricing; time changes; operational time; irregularly spaced data. (search for similar items in EconPapers)
Date: 2007-12
New Economics Papers: this item is included in nep-mst and nep-rmg
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https://eprints.bbk.ac.uk/id/eprint/26867 First version, 2007 (application/pdf)

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