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Liquidity Effects in Interest

Rate Options Markets:


Premium or Discount?
Prachi Deuskar
Anurag Gupta
Marti G. Subrahmanyam
Anurag Gupta, Case Western Reserve University
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)
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
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 non-
tradable currency options are discounted
Longstaff (1995) and Constantinides (1997) present
theoretical arguments why illiquid options should be
discounted
Anurag Gupta, Case Western Reserve University
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?
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
Sample Data (basis point prices)
Euro Caps/Floors Caps 2.00% 2.50% 3.00% 4.00% 5.00% 6.00%
1 Jahr (vs 3M)
2 Jahre 281-291 211-220 92-99
3 Jahre 636-657 521-540 409-425 213-227 99-111 45-53
4 Jahre 933-964 777-805 627-649 360-378 189-204 98-110
5 Jahre 1228-1269 1034-1072 847-877 515-540 292-314 165-182
6 Jahre 1300-1345 1078-1116 680-712 402-430 236-260
7 Jahre 1310-1356 847-887 515-550 311-341
8 Jahre 1021-1069 640-683 400-437
9 Jahre 1187-1241 760-810 482-525
10 Jahre 866-923 557-607
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
Scaled bid-ask spreads (Table 2)
Anurag Gupta, Case Western Reserve University
Panel GARCH Model for Benchmark
Volatility
Panel version of GJR-GARCH(1,1) model with square
root level dependence





Two alternative benchmarks for robustness:
Simple historical vol (s.d. of changes in log forward rates)
Comparable ATM diagonal swaption volatility
( )
0 1 ,
, 0 ~ ,
T 1, - t , 1 , 1
2
, 1 3
2
, 1 2
2
, 1 1 0
2
,
, 1 , ,
2
, , , , 1 1 0 ,
< = + + + =
=
+ + =

c c | c | o | | o
o
c c o o
if I I
f h
h N f f
T t T t T t T t T t T t
T t T t T t
T t T t T t T t T t
Anurag Gupta, Case Western Reserve University
Liquidity Price Relationship








Illiquid options appear to be more expensive
2 year caps/floors
-0.05
0
0.05
0.1
0.15
0 0.1 0.2 0.3 0.4
Rel BAS
E
I
V
5 year caps/floors
-0.04
0
0.04
0.08
0.12
0 0.04 0.08 0.12 0.16
Rel BAS
E
I
V
10 year caps/floors
-0.06
-0.01
0.04
0.09
0 0.04 0.08 0.12 0.16
Rel BAS
E
I
V
Anurag Gupta, Case Western Reserve University
Liquidity Price Relationship
Estimate a simultaneous equation model using 3-stage
least squares (liquidity and price may be endogenous)





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)
( )
( )
CpTbSprd d LiffeVol d DefSprd d *SwpnVol d
LMR d LMR d LMR d EIV d d RelBAS
Slope c Mrate c DefSprd c SwpnVol c
LMR c LMR c LMR c RelBAS c c EIV
LMR
LMR
* 9 * 8 * 7 6
. 1 * 5 * 4 * 3 * 2 1
* 9 6 * 8 * 7 6
. 1 * 5 * 4 * 3 * 2 1
0
2
0
2
+ + +
+ + + + + =
+ + +
+ + + + + =
<
<
Anurag Gupta, Case Western Reserve University
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!
Anurag Gupta, Case Western Reserve University
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)
Anurag Gupta, Case Western Reserve University
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


Average Correlations
OTM ATM ITM
OTM 0.68
ATM 0.34 0.86
ITM 0.24 0.65 0.78

Anurag Gupta, Case Western Reserve University
Extracting the common liquidity factor
Panel regression (9 maturities, 3 moneyness buckets
each)

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 R
2
of 9% (44,070 observations)
( ) . 1 * 5 * 4 * 3 * 2 1
0
2
it
it
LMR
it
it it it
LMR c LMR c LMR c EIV c c RelBAS c + A + A + A + A + = A
<
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
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
Anurag Gupta, Case Western Reserve University
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