TRADING ADVANTAGES OF STRUCTURED PRODUCTS AND OPTION IMPLIED LIQUIDITY
Madan, Dilip B
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The two-price market theory is based on a new performance measure - acceptability indices, and provides a new way to describe incomplete markets. Unlike the classical option pricing theory, in which the risk-neutral measure is unique and derivatives are bought or sold at the same prices, in two-price markets - the uniqueness of risk-neutral measure is not guaranteed, and derivative prices are determined by the direction of the trade. Based on the two-price market theory, this dissertation presents an argument for the advantages of trading options spreads and exotic options from investors' point of view. It is shown that from the investors' perspective, the price of buying these products is always lower than the price of trading their-component options separately, and the price of selling these options is always higher than the price of trading their-component options separately. The trading advantages of bull, bear, strangle and butterfly spreads, as well as cliquet options, reverse cliquet options and spread options, are illustrated with mathematical proofs and numerical work. We also investigated the role of volatility, maturity, stress level and market skewness in the trading benefits of these products. It is observed that the greater the complexity of structured products, the greater packaging benefits of trading them. Moreover, an investigation of liquidity risk implied by market option bid and ask prices was conducted. The liquidity risk parameter included in option bid and ask prices is modeled as a nonlinear function of strike prices and a linear function of maturities. The Variance Gamma Scaled Self-Decomposable process is used to model the risk-neutral process of the underlying asset. Calibration using market option bid and ask prices could help to reveal the model parameters. The analysis is performed on quarterly SPX, NDX and DJX options for the years 2007-2010. A detailed structure of the implied liquidity parameter suggests that call options are more liquid than put options. The implied liquidity parameter for at-the-money options suggests that great liquidity risk existed during the eruption of the subprime crisis in 2008.