Liquidity effect in OTC options markets: Premium or discount?

Prachi Deuskar, Anurag Gupta, Marti G. Subrahmanyam
<span title="">2011</span> <i title="Elsevier BV"> <a target="_blank" rel="noopener" href="https://fatcat.wiki/container/xagij2pg2vdxpnkhmp4e7oum5m" style="color: black;">Journal of financial markets</a> </i> &nbsp;
Can the liquidity premium in asset prices, as documented in the exchange-traded equity and bond markets, be generalized to the over-the-counter (OTC) derivative markets? Using OTC euro (€) interest rate cap and floor data, we find that illiquid options trade at higher prices relative to liquid options. This liquidity discount, though opposite to that found in equities and bonds, is consistent with the structure of this OTC market and the nature of its demand and supply forces. Our results
more &raquo; ... t that the effect of liquidity on asset prices cannot be generalized without regard to the characteristics of the market. JEL Classification: G10, G12, G13, G15 ABSTRACT Can the liquidity premium in asset prices, as documented in the exchange-traded equity and bond markets, be generalized to the over-the-counter (OTC) derivative markets? Using OTC euro (€) interest rate cap and floor data, we find that illiquid options trade at higher prices relative to liquid options. This liquidity discount, though opposite to that found in equities and bonds, is consistent with the structure of this OTC market and the nature of its demand and supply forces. Our results suggest that the effect of liquidity on asset prices cannot be generalized without regard to the characteristics of the market. JEL Classification: G10, G12, G13, G15 Keywords: Liquidity, interest rate options, euro interest rate markets, Euribor market, OTC options markets. SINCE THE SEMINAL PAPER by Amihud and Mendelson (1986), numerous theoretical and empirical studies in equity and fixed income markets have shown that stocks and bonds with lower liquidity have lower prices and command higher expected returns. 1 However, relatively little is known about the implications of liquidity for pricing in derivatives markets, such as those for equity or interest rate options. An exception in this relatively sparse literature is the study by Brenner, Eldor and Hauser (2001), who confirm the normally expected result that non-tradable currency options in Israel are discounted by 21 percent on average, as compared to exchangetraded options. 2 But is this always the case, especially for over-the-counter (OTC) options markets? Are illiquid options always priced lower than liquid options, similar to the liquidity effect consistently observed in the underlying asset markets, or does this depend on the institutional structure of the specific market, as suggested by Brenner, Eldor and Hauser (2001)? We raise and answer this important question using cap and floor data from the OTC interest rate options market, which is one of the largest (and yet least researched) options markets in the world, with about $52 trillion in notional principal and $700 billion in gross market value outstanding as of June 2007. 3 Contrary to the accepted wisdom in the existing literature based on evidence from other asset markets, we find that more illiquid interest rate options in the OTC markets trade at higher prices relative to the more liquid options, controlling for other effects. This effect goes in the direction opposite to what is observed for stocks, bonds, and even for some exchange-traded currency options. Our paper is the first to document such a liquidity effect in any financial market, and is also the first one to examine liquidity effects in the OTC options markets. This result has important implications for incorporating liquidity effects in derivative pricing models, since we 1 These include theoretical studies, such as Longstaff (1995a) and Longstaff (2001) , numerous empirical studies in the equity markets, several studies such as and others in the corporate bond market. 2 show that the conventional intuition, which holds in other asset markets, may not hold in some derivatives markets. Our study contributes to the existing literature in several ways. According to the available evidence, the impact of illiquidity on asset prices is overwhelmingly presumed to be negative, since the marginal investors typically hold a long position, thereby demanding compensation for the lack of immediacy they face if they wish to sell the asset. Thus, the liquidity premium on the asset is expected to be positive -other things remaining the same, the more illiquid an asset, the higher is its liquidity premium and its required rate of return, and hence, the lower is its price. For example, in the case of a bond or a stock, which are assets in positive net supply, the marginal investor or the buyer of the asset demands compensation for illiquidity, while the seller is no longer concerned about the liquidity of the asset after the transaction. In fact, within a two-asset version of the standard Lucas economy, Longstaff (2005) shows that a liquid asset can be worth up to 25 percent more than an illiquid asset, when both have identical cash flow dynamics otherwise. However, derivative assets are different from underlying assets like stocks and bonds. First, there is no reason to presume that liquidity in the derivatives markets is an exogenous phenomenon. Rather, it is the result of the availability and liquidity of the hedging instruments, the magnitude of unhedgeable risks, and the risk appetite and capital constraints of the marginal investors, among other factors. Thus, illiquidity in derivatives markets captures all of the concerns of the marginal investor about the expected hedging costs and the risks over the life of the derivative. In particular, in the case of options, since they cannot be hedged perfectly, the dealers are keen to carry as little inventory as possible, after allowing for hedging. Therefore, the liquidity of the option captures the ease with which a dealer can offset the trade. Consequently, the liquidity of an option matters to the dealers and has an effect on its price. Second, derivatives are generally in zero net supply. Therefore, in derivatives, it is not obvious whether the marginal investor concerned about liquidity holds a long or a short position. In addition, in the case of options, the risk exposures of the short side and the long side are not necessarily the same, since they may have other offsetting positions. Both the buyer and the seller continue to have exposure to the
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