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c c | c | o | | o
o
c c o o
if I I
f h
h N f f
T t T t T t T t T t T t
T t T t T t
T t T t T t T t T t
Anurag Gupta, Case Western Reserve University
Liquidity Price Relationship
Illiquid options appear to be more expensive
2 year caps/floors
-0.05
0
0.05
0.1
0.15
0 0.1 0.2 0.3 0.4
Rel BAS
E
I
V
5 year caps/floors
-0.04
0
0.04
0.08
0.12
0 0.04 0.08 0.12 0.16
Rel BAS
E
I
V
10 year caps/floors
-0.06
-0.01
0.04
0.09
0 0.04 0.08 0.12 0.16
Rel BAS
E
I
V
Anurag Gupta, Case Western Reserve University
Liquidity Price Relationship
Estimate a simultaneous equation model using 3-stage
least squares (liquidity and price may be endogenous)
First consider only near-the-money options (LMR
between -0.1 and 0.1)
Instruments for both liquidity and price (Hausman tests
to confirm that variables are exogenous)
( )
( )
CpTbSprd d LiffeVol d DefSprd d *SwpnVol d
LMR d LMR d LMR d EIV d d RelBAS
Slope c Mrate c DefSprd c SwpnVol c
LMR c LMR c LMR c RelBAS c c EIV
LMR
LMR
* 9 * 8 * 7 6
. 1 * 5 * 4 * 3 * 2 1
* 9 6 * 8 * 7 6
. 1 * 5 * 4 * 3 * 2 1
0
2
0
2
+ + +
+ + + + + =
+ + +
+ + + + + =
<
<
Anurag Gupta, Case Western Reserve University
Liquidity Price Relationship
c2 and d2 are positive and significant for all
maturities (table 3)
More liquid options are priced lower, while less liquid
options are priced higher, controlling for other effects
Results hold up to several robustness tests
Bid and ask prices separately
Two alternative volatility benchmarks
Options across all strikes (include controls for skewness and
kurtosis in the interest rate distribution)
Changes in liquidity change option prices
This result is the opposite of those reported for
other asset classes!
Anurag Gupta, Case Western Reserve University
Economic Significance
EIVs increase by 25-70 bp for every 1% increase in
relative bid-ask spreads
One s.d. shock to the liquidity of a cap/floor translates
to an absolute price change of 4%-8% for the
cap/floor
Longer maturity options have a stronger liquidity
effect
Higher EIVs when:
Interest rates are higher
Interest rate uncertainty is higher
Lower BAS when LIFFE futures volume is higher
(more demand for hedging interest rate risk)
Anurag Gupta, Case Western Reserve University
Are there common drivers of liquidity?
Compute average correlations between RelBAS
within moneyness buckets across maturities (table 9)
Some part of the variation appears to be systematic
Average Correlations
OTM ATM ITM
OTM 0.68
ATM 0.34 0.86
ITM 0.24 0.65 0.78
Anurag Gupta, Case Western Reserve University
Extracting the common liquidity factor
Panel regression (9 maturities, 3 moneyness buckets
each)
Include panel fixed effects
Disturbances:
Heteroskedastic
Potentially correlated across panels
Serially correlated within panels (AR(1))
Prais-Winsten full FGLS estimation
Re-estimate using alternative error structures and
estimation methods for robustness
c2 is positive, Adj R
2
of 9% (44,070 observations)
( ) . 1 * 5 * 4 * 3 * 2 1
0
2
it
it
LMR
it
it it it
LMR c LMR c LMR c EIV c c RelBAS c + A + A + A + A + = A
<
Anurag Gupta, Case Western Reserve University
Extracting the common liquidity factor
Examine the principal components of the residuals of
the panel regression
First factor explains 33% - suggests a market-wide
systematic component to these liquidity shocks
Parallel shock across all maturities and strikes higher
loading on OTM and ATM options
Second factor explains 11% (others insignificant)
Negative weight on OTM options, positive weight on
ATM/ITM options (more positive on ITM options)
Substitution effect demand may partially shift away from
ATM/ITM options to OTM options when the market is hit by
the second type of common liquidity shock
Anurag Gupta, Case Western Reserve University
Macro-economic drivers of Common
Liquidity Factor
Construct a daily (unexplained) systematic liquidity
factor based on the residuals and the first principal
component
Regress this factor on contemporaneous and lagged
changes in macro-economic variables
Short rate and slope of the term structure do not
appear to heave any effect on this factor
Default spread not related as well dealers are
mostly on the sell side
Uncertainties in fixed income and equity markets
appear to drive this systematic liquidity factor, with a
lag of 1-4 days
Anurag Gupta, Case Western Reserve University
Contributions
Contrary to existing findings for other assets, we
document a negative relationship between liquidity
and price conventional intuition doesnt always hold
A significant common factor drives changes in
liquidity in this options market
Changes in uncertainty in fixed income and equity markets
drive this common liquidity factor
Anurag Gupta, Case Western Reserve University
Implications of our Study
Estimation of liquidity risk for fixed income option
portfolios GARCH models could be useful
Hedging liquidity risk in fixed income option portfolios
could form macro-hedges using equity and fixed
income options
Macro-economic drivers of liquidity provide some
guidelines for including liquidity as a factor in fixed
income option pricing models