Implied liquidity risk premia in option markets

The theory of conic finance replaces the classical one-price model by a two-price model by determining bid and ask prices for future terminal cash flows in a consistent manner. In this framework, we derive closed-form solutions for bid and ask prices of plain vanilla European options, when the density of the log-returns is log-concave. Assuming that log-returns are normally or Laplace distributed, we apply the results to a time-series of real market data and compute an implied liquidity risk premium to describe the bid-ask spread. We compare this approach to the classical attempt of describing the spread by quoting Black-Scholes implied bid and ask volatilities and demonstrate that the new approach characterize liquidity over time significantly better.

Publication year:2019

Keywords:A1 Journal article

Accessibility:Closed