Liquidity Effects in Interest

Rate Options Markets:

Premium or Discount?
Prachi Deuskar
Anurag Gupta
Marti G. Subrahmanyam

Objectives
How does illiquidity affect option prices?
What drives liquidity in option markets?

We study these two questions in the Euro interest rate

options markets (caps/floors)

Related Literature Equity Markets

Illiquid / higher liquidity risk stocks have lower prices

(higher expected returns)

Amihud and Mendelsen (1986), Pastor and Stambaugh

(2003), Acharya and Pedersen (2005), and many others

Significant commonality in liquidity across stocks

Chordia, Roll, and Subrahmanyam (2000), Hasbrouck and

Seppi (2001), Huberman and Halka (2001), Amihud (2002),
and many others

Related Literature Fixed Income Markets

Illiquidity affects bond prices adversely

Amihud and Mendelsen (1991), Krishnamurthy (2002),

Longstaff (2004), and many others
More recent papers include Chacko, Mahanti, Mallik,
Nashikkar, Subrahmanyam (2007) and Mahanti, Nashikkar,
Subrahmanyam (2007)

Common factors drive liquidity in bond markets

Chordia, Sarkar, and Subrahmanyam (2003), Elton, Gruber,

Agarwal, and Mann (2001), Longstaff (2005), and many
others

Related Literature Derivative Markets

Relatively little is known
Vijh (1990), Mayhew (2002), Bollen and Whaley

(2004) present some evidence from equity options

Brenner, Eldor and Hauser (2001) report that nontradable currency options are discounted
Longstaff (1995) and Constantinides (1997) present
theoretical arguments why illiquid options should be
discounted

How should illiquidity affect asset prices?

Negatively, as per current literature
Conventional wisdom: More illiquid assets must have

higher returns, hence lower prices

The buyer of the asset demands compensation for
illiquidity, while the seller is no longer concerned
about liquidity
True for assets in positive net supply (like stocks)
Is this true for assets that are in zero net supply,
where the seller is concerned about illiquidity, and
also about hedging costs?

How should liquidity affect derivative prices?

Derivatives are generally in zero net supply
Risk exposures of the short side and the long side

may be different (as in the case of options)

Both buyer and seller continue to have exposure
even after the transaction
The buyer would demand a reduction in price, while
the seller would demand an increase in price
If the payoffs are asymmetric, the seller may have
higher risk exposures (as is the case with options)
Net effect is determined in equilibrium, can go either
way

How should illiquidity affect interest rate

option prices?
Caps/floors are long dated OTC contracts
Mostly institutional market
Sellers are typically large banks, buyers are

corporate clients and some smaller banks

Customers are usually on the ask-side
Buyers typically hold the options, as they may be
hedging some underlying interest rate exposures
Sellers are concerned about their risk exposures, so
they may be more concerned about the liquidity of
the options that they have sold
Marginal investors likely to be net short

Unhedgeable Risks in Options

Long dated contracts (2-10 years), so enormous

transactions costs if dynamically hedged using the

underlying
Deviations from Black-Scholes world (stochastic
volatility including USV, jumps, discrete rebalancing,
transactions costs)
Limits to arbitrage (Shleifer and Vishny (1997) and
Liu and Longstaff (2004))
Option dealers face model misspecification and
biased paramater estimation risk (Figlewski (1989))
Some part of option risks is unhedgeable

Upward Sloping Supply Curve

Since some part of option risks is unhedgeable
Option liquidity related to the slope of the supply

curve

Illiquidity makes it difficult for sellers to reverse trades have

to hold inventory (basis risk)
Model risk fewer option trades to calibrate models

Hence supply curve is steeper when there is less

liquidity

Wider bid-ask spreads

Higher prices, since dealers are net short in the aggregate

Data
Euro cap and floor prices from WestLB (top 5

German bank) Global Derivatives and Fixed Income

Group (member of Totem)
Daily bid/ask prices over 29 months (Jan 99-May01)
nearly 60,000 price quotes
Nine maturities (2-10 years) across twelve strikes
(2%-8%) not all maturity strike combinations
available each day
Options on the 6-month Euribor with a 6-month reset
Also obtained Euro swap rates and daily term
structure data from WestLB

Sample Data (basis point prices)

Data Transformation
Strike to LMR (Log Moneyness Ratio) logarithm of

the ratio of the par swap rate to the strike rate of the
option
EIV (Excess Implied Volatility) difference between
the IV (based on mid-price) and a benchmark
volatility using a panel GARCH model

Using IV removes term structure effects

Subtracting a benchmark volatility removes aggregate
variations in volatility
Hence its a measure of expensiveness of options
Useful for examining factors other than term structure or
interest rate uncertainty that may affect option prices

Scaled bid-ask spreads (Table 2)

Panel GARCH Model for Benchmark

Volatility
Panel version of GJR-GARCH(1,1) model with square

root level dependence

f t ,T 0 1 f t 1,T t ,T ,

t ,T ~ N 0, ht2,T

ht ,T t ,T f t 1,T

t2,T 0 1 t21,T 2 t21,T 3 t21,T I t1,T ,

I t1,T 1 if t-1,T 0

Two alternative benchmarks for robustness:

Simple historical vol (s.d. of changes in log forward rates)

Comparable ATM diagonal swaption volatility

Liquidity Price Relationship

Illiquid options appear to be more expensive

Liquidity Price Relationship

Estimate a simultaneous equation model using 3-stage

least squares (liquidity and price may be endogenous)

EIV c1 c 2 * RelBAS c3 * LMR c 4 * LMR 2 c5 * 1LMR0.LMR

c6 SwpnVol c7 * DefSprd c8 * 6 Mrate c9 * Slope
RelBAS d 1 d 2 * EIV d 3 * LMR d 4 * LMR 2 d 5 * 1LMR0.LMR
d 6*SwpnVol d 7 * DefSprd d 8 * LiffeVol d 9 * CpTbSprd
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)

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!

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)

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

Extracting the common liquidity factor

Panel regression (9 maturities, 3 moneyness buckets

each)

RelBASit c1 c 2 * EIVit c3 * LMRit c 4 * LMR 2 it c5 * 1LMR0. LMR it it

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 R2 of 9% (44,070 observations)

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

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

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

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