The Drivers and Pricing of Liquidity in Interest Rate Option Markets

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.