Option pricing with stochastic liquidity risk: Theory and evidence

Abstract

This study develops a liquidity-adjusted option pricing model that demonstrates the impact of the liquidity risk on stock prices using a liquidity discount factor. The discount factor relates to both mean-reversion stochastic market liquidity and the sensitivity of stock prices to market illiquidity. Our empirical results provide strong evidence in support of incorporating liquidity risk in options pricing. In particular, our model shows marked pricing improvement for out-of-the-money or longer term options, as well as options on stocks with lower levels of liquidity.