A closed-form pricing formula for European options in an illiquid asset market
Abstract This article addresses the problem of pricing European options when the underlying asset is not perfectly liquid. A liquidity discounting factor as a function of market-wide liquidity governed by a mean-reverting stochastic process and the sensitivity of the underlying price to market-wide...
| Main Authors: | , , |
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| Format: | Article |
| Language: | English |
| Published: |
SpringerOpen
2022-04-01
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| Series: | Financial Innovation |
| Subjects: | |
| Online Access: | https://doi.org/10.1186/s40854-022-00337-6 |
| _version_ | 1828733979375697920 |
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| author | Puneet Pasricha Song-Ping Zhu Xin-Jiang He |
| author_facet | Puneet Pasricha Song-Ping Zhu Xin-Jiang He |
| author_sort | Puneet Pasricha |
| collection | DOAJ |
| description | Abstract This article addresses the problem of pricing European options when the underlying asset is not perfectly liquid. A liquidity discounting factor as a function of market-wide liquidity governed by a mean-reverting stochastic process and the sensitivity of the underlying price to market-wide liquidity is firstly introduced, so that the impact of liquidity on the underlying asset can be captured by the option pricing model. The characteristic function is analytically worked out using the Feynman–Kac theorem and a closed-form pricing formula for European options is successfully derived thereafter. Through numerical experiments, the accuracy of the newly derived formula is verified, and the significance of incorporating liquidity risk into option pricing is demonstrated. |
| first_indexed | 2024-04-12T22:40:08Z |
| format | Article |
| id | doaj.art-1a6b98518d744778b5966f01fe51b4c4 |
| institution | Directory Open Access Journal |
| issn | 2199-4730 |
| language | English |
| last_indexed | 2024-04-12T22:40:08Z |
| publishDate | 2022-04-01 |
| publisher | SpringerOpen |
| record_format | Article |
| series | Financial Innovation |
| spelling | doaj.art-1a6b98518d744778b5966f01fe51b4c42022-12-22T03:13:46ZengSpringerOpenFinancial Innovation2199-47302022-04-018111810.1186/s40854-022-00337-6A closed-form pricing formula for European options in an illiquid asset marketPuneet Pasricha0Song-Ping Zhu1Xin-Jiang He2School of Mathematics and Applied Statistics, University of WollongongSchool of Mathematics and Applied Statistics, University of WollongongSchool of Economics, Zhejiang University of TechnologyAbstract This article addresses the problem of pricing European options when the underlying asset is not perfectly liquid. A liquidity discounting factor as a function of market-wide liquidity governed by a mean-reverting stochastic process and the sensitivity of the underlying price to market-wide liquidity is firstly introduced, so that the impact of liquidity on the underlying asset can be captured by the option pricing model. The characteristic function is analytically worked out using the Feynman–Kac theorem and a closed-form pricing formula for European options is successfully derived thereafter. Through numerical experiments, the accuracy of the newly derived formula is verified, and the significance of incorporating liquidity risk into option pricing is demonstrated.https://doi.org/10.1186/s40854-022-00337-6European optionsLiquidity riskLiquidity discounting factorCharacteristic functionConditional distribution |
| spellingShingle | Puneet Pasricha Song-Ping Zhu Xin-Jiang He A closed-form pricing formula for European options in an illiquid asset market Financial Innovation European options Liquidity risk Liquidity discounting factor Characteristic function Conditional distribution |
| title | A closed-form pricing formula for European options in an illiquid asset market |
| title_full | A closed-form pricing formula for European options in an illiquid asset market |
| title_fullStr | A closed-form pricing formula for European options in an illiquid asset market |
| title_full_unstemmed | A closed-form pricing formula for European options in an illiquid asset market |
| title_short | A closed-form pricing formula for European options in an illiquid asset market |
| title_sort | closed form pricing formula for european options in an illiquid asset market |
| topic | European options Liquidity risk Liquidity discounting factor Characteristic function Conditional distribution |
| url | https://doi.org/10.1186/s40854-022-00337-6 |
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