The Liquidity Effect in Option Pricing : An Empirical Analysis

This paper empirically examines whether asset's liquidity can help resolve the known strike-price biases of the Black-Scholes model for different liquidity measures based on trading volume, bid-ask spread and the Amihud's ILLIQ. Our results indicate that, when the underlying asset or its derivative exhibit lower liquidity, the degree of curvature of the strike-price biases will tend to increase, regardless of the liquidity measures used. Furthermore, inspection of 2R reveals that the stock's liquidity has an excellent ability in explaining the strike-price biases compared with the option's liquidity in terms of the liquidity measures based on trading volume and the Amihud's ILLIQ