“The Price of Options Illiquidity” by Rafael ELDOR
Interdisciplinary Center Herzliya
New York University
Ben Gurion University
The purpose of this paper is to examine the effect of illiquidity on the value of currency options. We use a unique data set which allows us to explore this issue in special circumstances where options are issued by a central bank and are not traded prior to maturity. The value of these options is compared to similar options traded on the exchange. We find that the non-tradable options are priced about 21% less than the exchange traded options. This gap cannot be arbitraged away due to transaction costs and the risk that the exchange rate will change during the bidding process.