Volatility Uncertainty, Time Decay, and Option Bid-Ask Spreads

Abstract

This paper documents the fact that in option markets, the percentage implied volatility bid-ask spread increases at an increasing rate as the option's maturity date approaches. We construct an equilibrium model to explain this phenomena. The equilibrium model has risk averse and competitive option market makers quoting bid and asking prices to minimize their inventory risk in an incomplete market with both directional and volatility risk. Two additional testable implications of the model are generated. These are that: (1) an increase in the level of the underlying volatility decreases an option's percentage implied volatility bid-ask spread, and (2) holding the level of the volatility constant, an increase in the volatility's variance also increases an option's percentage implied volatility bid-ask spread. These additional implications are empirically tested using index options on the Taiwan stock price index over the time period 2007-2010. The empirical results confirm the model's validity.