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RFS Advance Access published online on January 20, 2006
Review of Financial Studies, 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

Article

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

U. Çetin 1, R. Jarrow 2 *, P. Protter 3, and M. Warachka 4
1 Department of Statistics, London School of Economics and Political Science, London, England, WC2A 2AE
2 Johnson Graduate School of Management, Cornell University, Ithaca, New York, 14853
3 School of Operations Research and Industrial Engineering, Cornell University, Ithaca, New York, 14853; Supported in part by NSF Grant DMS-0202958 and NSA Grant 904-00-1-0035
4 School of Business, Singapore Management University, Singapore, 259756; Supported by Wharton-SMU Research Center, Singapore Management University

* To whom correspondence should be addressed.
R. Jarrow, E-mail: raj15{at}cornell.edu


  Abstract

This paper 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.

Keywords: Option Pricing, Liquidity, Black Scholes.
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