The Effects of Market Frictions on Option Prices

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Classic option-pricing theory assumes that assets are traded on frictionless markets. In reality, however, different market frictions prevail, for example, asset illiquidity and funding restrictions for certain groups of market participants. Such market frictions can be substantial, as was observed during the global financial crisis of 2008 and 2009, and can have an important impact on option prices. The goal of this project is to understand how market frictions affect option prices and option returns. A major challenge for such an investigation is that the direction of price effects depends on net end-user demand for options. If the demand is positive, i.e., end-users want to buy options, market frictions should lead to higher prices, whereas a negative demand should lead to lower prices. Unfortunately, data on end-user demand, in particular for options on individual stocks, is rarely available. Therefore, an essential idea of the project is to develop and empirically test hypotheses about the relation between market frictions and option prices which don't require any knowledge of end-user demand in a first step. This step exploits the idea that frictions should increase the variation of option prices around an appropriate reference value. If the hypotheses are supported by empirical tests for the US stock options market, we can draw conclusions about end-user demand from the difference between option prices and reference values in a second step.The project's main question about the connection between market frictions and option prices is relevant both from a scientific and socio-political perspective. In face of the controversial debate about derivatives markets a better understanding of the functioning of these markets is very important for policy recommendations concerning the design of corporate risk management strategies as well as the design and regulation of options markets. By looking at different market frictions (illiquidity, incompleteness of markets, funding restrictions) and investigating their relative importance for price formation in different market periods the project makes an important contribution in this respect.