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RFS Advance Access originally published online on January 20, 2006
Review of Financial Studies 2006 19(2):493-529; doi:10.1093/rfs/hhj014
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© The Author 2006. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For permissions, please email: journals.permissions@oxfordjournals.org.

Pricing Options in an Extended Black Scholes Economy with Illiquidity: Theory and Empirical Evidence

U. Çetin
Department of Statistics, London School of Economics and Political Science

R. Jarrow
Johnson Graduate School of Management, Cornell University

P. Protter
School of Operations Research and Industrial Engineering, Cornell University

M. Warachka
School of Business, Singapore Management University

Address correspondence to Robert Jarrow, 451 Sage Hall, Johnson Graduate School of Management, Cornell University, Ithaca, NY 14853-6201, or email: raj15{at}cornell.edu.

This article studies the pricing of options in an extended Black Scholes economy in which the underlying asset is not perfectly liquid. The resulting liquidity risk is modeled as a stochastic supply curve, with the transaction price being a function of the trade size. Consistent with the market microstructure literature, the supply curve is upward sloping with purchases executed at higher prices and sales at lower prices. Optimal discrete time hedging strategies are then derived. Empirical evidence reveals a significant liquidity cost intrinsic to every option.


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