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Please use this identifier to cite or link to this item:
http://hdl.handle.net/2451/26438
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| Title: | The Drivers and Pricing of Liquidity in Interest Rate Option Markets |
| Authors: | DEUSKAR, PRACHI
GUPTA, ANURAG
SUBRAHMANYAM, MARTI G. |
| Issue Date: | Nov-2005 |
| Series/Report no.: | FIN-05-036 |
| Abstract: | The objectives of this paper are to examine the effect of liquidity on
interest rate option prices, and to determine whether it is driven by a
common systematic factor. Using daily bid and ask prices of euro
(€) interest rate caps/floors, we document a negative effect of
liquidity on option prices – illiquid options trade at higher
prices relative to liquid options, after controlling for the volatility
smile and term structure variables. This is opposite to the evidence for
other assets such as equities, bonds and currency options. We also
identify a systematic common factor that drives liquidity, across option
maturities and strike rates. This liquidity factor is driven by the
changes in uncertainty in the equity and fixed income markets. Our
results have important implications for the pricing and hedging of
liquidity risk in derivatives markets. |
| URI: | http://hdl.handle.net/2451/26438 |
| Appears in Collections: | Finance Working Papers
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