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- Steilermeier
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Options Pricing with Illiquid Underlying
Hi guys,are there standard papers to read through when entering an options market with illiquid underlying. I assume that due to increased hedge costs the theoretical fair value can't be realised by continously hedging. But how much would this discount be?Thank you for your help!Steilermeier
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- Steilermeier
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Options Pricing with Illiquid Underlying
Thank you @almostcutmyhair.Is this THE standard paper? Is this also used in practice? Because eventually I would like to use this in a real environment...
Options Pricing with Illiquid Underlying
By and large no one seems to care if the underlying is illiquid. They still use BS and associated models even when not relevant. Just look at the atrocious state of credit models.P
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- Cuchulainn
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Options Pricing with Illiquid Underlying
QuoteOriginally posted by: PaulBy and large no one seems to care if the underlying is illiquid. They still use BS and associated models even when not relevant. Just look at the atrocious state of credit models.PIs this also true when the underlying is a physical illiquid commodity?
Last edited by Cuchulainn on September 20th, 2013, 10:00 pm, edited 1 time in total.
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- Steilermeier
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Options Pricing with Illiquid Underlying
@Paul: Does this mean I should make the same mistakes as the rest? Or are you saying that since nobody cares I have to come up with my own solution and can pick up ideas from literature / papers because there are none?@Cuchulainn: This is exactly my practical application...I want to price in an illiquidity premium but instead of taking some rough guess from the trader I want to have mathematical approach that I can compare with the ballpark number and then decide we are good to go or either the model or the trader is wrong.
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- Cuchulainn
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Options Pricing with Illiquid Underlying
I think the normal models will be wrong.just a guess...I reckon there will be 2 prices (bid-ask). So if you have an illiquid asset and you want to sell it and you can't what then? A trader offers 300 although according to the accountants it is 1000.Would Paul's Uncertain PDE models be useful here?
Last edited by Cuchulainn on September 27th, 2013, 10:00 pm, edited 1 time in total.
Options Pricing with Illiquid Underlying
It's not 'my' uncertain model. It's Avellaneda et al's. However, my et al's transaction cost model might be relevant.@Steilermeier: There are plenty of ideas in the literature but I don't know any that are practical. Always best to diversify if you can't hedge.P
Options Pricing with Illiquid Underlying
My 2p approach that accountants/auditors seem to agree with would be to:- mark at cost and use the model to mark variation of value. - try to quantify a reserve for liquidity, model risk with some approach for which you could argueThere is most likely no good way but has to make sense
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- Steilermeier
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Options Pricing with Illiquid Underlying
Hi,for simplicity, I started with the model of Leland's transaction costs and used the formulas in Paul Wilmott on Quantitative Finance, page 785. For a quick numerical check I assumed the following values:sigma = 20%dt = 1 / 365k = 1%But then the formula for long positions is infeasible since the part within the outer sqrt is negative. When I had a look in the orginal paper, I found that the 8 is actually a 2. Or am I missing something stupidly? Which formula ist correct?
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- Steilermeier
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Options Pricing with Illiquid Underlying
I guess the difference comes from the definition of k. Leland defines it as the round trip cost, while Paul defines it as half the round trip cost, right? And then the two formulas are consistent.But the issue of infeasibility remains, does it?