Market illiquidity and the Bid-Ask spread of derivatives

Joao Amaro de Matos and Paula Antao

Nova SBE Working Paper Series from Universidade Nova de Lisboa, Nova School of Business and Economics

Abstract: This paper analyzes the impact of illiquidity of a stock on the pricing of derivatives. In particular, it is shown how illiquidity generates a bid-ask spread in an option on this stock, even in the absence of other imperfections, such as transaction costs and asymmetry of information. Moreover, the spread is shown to be asymmetric with respect to the option price under perfect liquidity. This fact explains the appearance of a smile effect when the implied volatility is estimated from the mid-quote.

Pages: 39 pages
Date: 2000
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Persistent link: https://EconPapers.repec.org/RePEc:unl:unlfep:wp386

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