This article was authored by Bryan Goh, First Avenue Partners LLP, London.
In 2008, investors quickly became acquainted with the concept of liquidity, or the lack of it. But what do we mean by liquidity, and how do we price it?
Liquidity premia are already priced in some markets such as the treasury market where the spread between on and off the runs is the implied liquidity premium. But how about markets where you have a single asset and there is no concept of off and on the runs? I would like to look at liquidity from the point of view of option implied volatility in order to understand the relationship between volatility and liquidity in more detail. There are two effects at play which are somewhat inter-related which complicates how we think of the dynamics between volatility and liquidity. I would also like to think of these relationships in a non-mathematical way to avoid the complexities that mathematical rigor would introduce. Let’s just get the picture right before we go further.
Volatility tends to rise in liquidity crises. There are two possibilities here. The first is that volatility increases with decreasing liquidity. The second is that the unobserved continuous time volatility is unchanged but that decreased liquidity results in prices being observable with lower frequency (a......................
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