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June 26 Workshop: Illiquidity Premia in Equity Option Markets

JUNE 27, 2014

Presenter: P. Christoffersen, University of Toronto, Rotman School of Management Research (Podcast)
Stream: Risk Management and Market Liquidity (Stream 3)
Discussant: P. Baxter, Managing Director, Equity Derivatives at TD Securities (Podcast)

Illiquidity is well-known to be a significant determinant of stock and bond returns. P. Christoffersen and his team report are the first to report on illiquidity premia in equity option markets. An increase in option illiquidity decreases the current option price and predicts higher expected option returns. This effect is statistically and economically significant. It is robust across different empirical approaches and when including various control variables. The illiquidity of the under- lying stock affects the option return negatively, consistent with a hedging argument: When stock market illiquidity increases, the cost of replicating the option goes up, which increases the option price and reduces its expected return. P. Baxter discussed how major changes over the last ten years have altered the microstructure of option markets and led to a gap between apparent liquidity and effective liquidity.