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Aug 2001

DAVID BAKSTEIN’S

LET IT

Real-world markets do not always

subscribe to the Black-Scholes

FLOW

THE PRICING OF DERIVATIVES

assumption of complete liquidity. IN ILLIQUID MARKETS

Here David Bakstein finds a real-

will be, in general, a nonlinear monotonically increasing

istic method for parameterizing the function of trade size.

effects of finite liquidity and develops Secondly, liquidity is directly responsible for the degree

of market slippage. This means that, since every participant

models for pricing derivatives in a can observe the same market depth, every trade of any

T

less-than- perfect market one agent is felt throughout. If a large trader removes a

certain price level in its entirety then market makers may

wo of the underlying assumptions of, adjust their prices subsequently. This results in compara-

amongst others, the basic Black-Scholes or tively large individual transactions or influential market

CAPM economies are first, frictionless participants pushing the asset price in a certain direction, in

markets and second, that every agent is a some cases deliberately (see Taleb, 1997). Hence there is

price-taker. However, real-world markets a market manipulation effect associated with liquidity that

substantially deviate from these assumptions because, for goes beyond pure transaction costs. The two effects may

virtually all traded assets, there exist both bid-ask spreads have opposite signs, although for the market to be free of

and a limited market depth. The effects of the two on asset arbitrage, transaction costs have to be higher than the

dynamics are loosely referred to as liquidity, meaning the gains from market manipulation.

more of an asset that is tradable at tight spreads, the more Generally, however, there is no consensus approach to

liquid, and thus attractive, a market. A vast amount of the parameterization and measurement of the liquidity of

research is being currently conducted on how to measure, a market. The papers of Longstaff (1995), and Chordia,

parameterize, price and manage liquidity in most fields of Roll and Subrahmanyam (2000), use combinations of

finance. This includes the extension of basic arbitrage or bid-ask spreads, volume and open interest as a proxy to

equilibrium models to cover the case of finite liquidity. empirically investigate the effects on returns and distribu-

The latter has two main effects. First, it represents a tions of the underlying and options on it. The papers of

random transaction cost which is correlated with the Jarrow (1992), Schönbucher (1993), Frey (1996),

market’s dynamics. In general, a market consists of Almgren & Chriss (1999) and Huberman & Stanzl (2000),

competing buyers and sellers, who quote an asset’s propose liquidity models that feature a reaction function

transaction directions, prices and quantities. The most that models the immediate impact of a trade and the aver-

common exchange structures are, respectively, a age price paid per asset. It is also a function of both a

monopolistic market maker, an oligopoly of market liquidity scaling parameter and the trade size. A possible

makers or an order-driven market. In all cases, there will proxy for the former is explicitly given by Krakovsky

be layers of bid and ask quotes with the respective quan- (1999), as the ratio of notional traded to the relative

tities. The width and depth of the spreads represent change in the price of the underlying asset. This choice of

primarily a transaction cost for market makers (since they estimator has the advantage that, at the time of the trade,

will buy low and sell high) and, also, an insurance against the liquidity parameter is observable and predictable. The

asymmetric information. Generally, if many competing papers by Almgren & Chriss (1999), Price-Impact Func-

market participants that want to trade exist , bid-ask tions, Huberman & Stanzl (2000) and Optimal Liquidity

spreads tend to be narrow and market depth substantial Trading, Huberman & Stanzl (2000), further consider the

because low transaction cost will attract large volume. permanent slippage effect on the asset, by making its new

However, whereas it may be possible for agents to trade equilibrium price a function of both the previous and the

small quantities of an asset at the best possible price, the average transaction price. However, they only apply their

larger the trade size the more levels of market depth will models to optimal portfolio trading strategies.

have to be tapped. Hence the average transaction price

1

David Bakstein’s Let it Flow Wilmott July 2001

OPTIONS (1)

One area of finance where liquidity is a significant factor

is the valuation and hedging of options. Even if no single where . The bond on the other hand will always yield the

trader has the intention to push the market in a certain riskless return , namely

direction, there exist agents who have to trade certain

quantities of the underlying in order to hedge their expo- (2)

sure to a portfolio of derivatives. If, as in the

Black-Scholes theory, they try and Delta-hedge, then for Moreover, we can set the initial values of stock and

options with non-smooth or even-discontinuous payoffs, bond equal to and , without loss of gener-

the Delta and Gamma, i.e. the amount of the underlying ality. Two key properties of the model are, firstly, the

they have to hold and add/remove, respectively, may absence of arbitrage provided that

become very large close to expiry or close to payoff and, secondly, that for appropriate choice of , and the

discontinuities. Since, in reality, markets only have risk-neutral probability the model’s first two moments,

limited liquidity, they will thereby automatically move the approximately, can be fitted to the corresponding

market in a certain direction. To avoid any mis-hedging, moments of continuous geometric Brownian motion

the respective ratios have to be adjusted for this feed-

back effect. This in turn will affect the price of the (3)

portfolio, since the risk-free amount that can be earned

on a replicating portfolio changes as well. Moreover, the where is the assets volatility and increments of

price of a portfolio of options is not the sum of the indi- standard Brownian motion. The same model is employed

vidual options. in the seminal paper by Black & Scholes (1973), as the

To incorporate the effects of finite liquidity into option model for the underlying asset.

prices and hedging strategies, we employ a discrete-time On top of this random process for the underlying we

model, based on binomial trees. For the transaction cost construct a controlled process that represents the effect

effect we make the observable asset price an exponen- of a large or influential trader on the market. We denote

tial function of the trade size, scaled by a liquidity this trader’s holding process in the stock by

parameter. For the permanent slippage effect, we take a and in the bond by . Both processes are

geometric average of the last observed and the average adapted to the filtration and one step

transaction price. This makes the model nonlinear. We ahead predictable with respect to it. The latter point

show that under certain realistic assumptions the trees entails, that the trader’s portfolio can be rebalanced in

become recombining and can be implemented. By between the random jumps of the underlying asset. If we

changing the sign of the option payoff, we derive natural now assume that represents the mid-market price,

bid-ask spreads of the option that arise from the degree then the best buying and selling prices will be above and

of illiquidity of the market for the underlying. Finally, we below, respectively. Also, if the quantity traded is larger

mention some further extensions to and applications of than the quantity offered at the best price, then more than

the basic model. one quote has to be filled in order to complete the trade.

This means that the average transaction price is a

THE BASIC MODEL monotonically increasing function of the trade size. We

The main building block for the pricing framework of define its process as a function of the current

derivatives and portfolio trades is a suitable model for the spot , liquidity and trade size . Intu-

underlying asset. We thus commence our analysis in a itively, the trade-reaction or price-impact function, in

discrete-time finite horizon economy where trading in addition to being monotonous and positively sloped with

assets takes place at times . The respect to the trade size, should have the properties that

state of the economy is given by the finite set

and the revelation of the true state by

the increasing sequence of algebras . The Figure 1: Average Transaction Prices

initial set of states is , the eventual true state of

the economy is revealed as , . There are ,

two assets, namely a risky stock and a riskless

bond , whose respective processes are adapted to the

filtration and valued in . ,

Resorting to the widely used binomial model of Cox,

Ross & Rubinstein (1979), we will model randomness,

which represents the arrival of information and agents .

trading in the stock, by making the risky asset go up by a

fraction with probability or down by a fraction One possible function as already noted in Jarrow

with probability over one time step. Therefore (1992) and Frey (1996) is

2

David Bakstein’s Let it Flow Wilmott July 2001

(4) , (7)

where is a liquidity scaling parameter and we as the model for the dynamics of the underlying. Even

suppressed the explicit dependence on the trajectory . though the latter is a computationally convenient model for

As an example, Figure 1 shows the exact average high-dimensional portfolio trading applications, it may

transaction price as a function of trade size for an order cause concerns when applied to the pricing of derivatives,

book with homogeneous equidistant market depth and mainly due to the fact that the spot of the underlying may

compares it with an estimate obtained from Equation (4). become negative with positive probability. In the standard

The total cash flow and implicit transaction cost are geometric Brownian motion this is only possible with zero

given by and , probability.

respectively. Unlike the transaction cost functions of

Boyle and Vorst(1992) and Edirisinghe et al (1993), THE HEDGING AND PRICING OF

Equation (4) is asymmetric, but does not require the VANILLA OPTIONS UNDER T H E

modulus sign, which, as we will see, makes it possible to BASIC MODEL

remove the path dependence and make the resulting Contingent claims are valued in reference to the initial

tree recombining. value of a portfolio strategy in the underlying risky and

In addition to the transaction cost effect, there is a riskless assets. This self-financing hedging strategy

1

market manipulation effect that is felt by all participants, , with , will exactly repli-

since the best quotes have been removed from the order cate or super-replicate any payoffs of the claim

book. Unlike Jarrow (1992 and 1994), Schönbucher . For a discrete time economy the valuation

(1993), Frey (1996) and Krakovsky (1999), the papers by of European vanilla-type contingent claims under our finite

Almgren & Chriss (1999) and Hubermann & Stanzl (2000) liquidity model can then be formulated as a non-linear

treat the reaction function as an instantaneous price programme with objective function

impact and they distinguish a permanent price update

effect, which is a function of both the previous equilibrium (8)

and the average transaction price. An intuitive explanation

is that large trades may not contain fundamental new infor-

mation, which would push the market to an untenable subject to initial holding, the self-financing and payoff

price level. A mathematically convenient model for this super-replication constraints

effect is to make the new equilibrium log-price a linear

combination of the two previous equilibrium and average , (9)

transaction log-prices or, equivalently, a geometric aver-

age of the two prices: (10)

(5)

price is a convex combination. However, , realisti- (11)

cally, can be negative, since in general the average

transaction price is, depending on the trade direction, ,

below or above the last price traded, unless only one

level of market depth was filled. Combining the instanta- respectively, where the processes of are

neous trade-reaction (4), the permanent slippage (5) and given by (2) and (6). Because, in general, , and

reverting to the binomial representation (1) we obtain thus are functions of the present and past stock-

the price dynamics holdings, the problem is path-dependent and the n u m b e r

of variables as well as constraints is exponentially

growing as the number of time steps increases. As an

example, we consider the three period economy with the

set of states and the filtra-

2

. (6) tion. , ,

and .

Then the asset’s dynamics are

This model setup, albeit structured similarly, is differ-

ent from those of Almgren & Chriss (1999), and

Hubermann & Stanzl (2000) who, in their respective

papers, resort to arithmetic Brownian motion

3

David Bakstein’s Let it Flow Wilmott July 2001

Figure 2: Asset Tree for α≠0

The asset tree becomes recombining and thus feasible

to implement. The asset’s dynamics are visualized in

Figure 2. Under the special case where the

process reduces to Figure 3. The case entails that

any price impact due to large trades is a permanent

effect in its entirety.

Nevertheless, it represents a possibly large scale

nonlinear optimization problem. To solve for the holding

process we have to resort to an opti-

misation algorithm that will converge quickly. One

standard possibility is the Newton method:

, where

have to solve the system of implicit nonlinear functions

and

time steps, respect i v e l y, and

for notational conven-

ience. Furthermore, the intermediate self-financing

conditions (11) span the system

3

variables/constraints, a two-period model has six vari- and

ables/constraints and an -period model

variables/constraints. The controlled process makes the

asset tree bushy and thus hard to implement.

However, when we turn the inequality (11) into an equal-

ity for Markovian contingent claims, two distinct trajectories

with an identical number of up and down moves at a time

will result in identical holdings in stock and bond e.g. ,

. We refer to this condition as the

‘justified manipulation’ effect. Because market manipulation , and suppressing the explicit

or front-running are normally illegal, the condition gives the dependence on .

4

David Bakstein’s Let it Flow Wilmott July 2001

Figure 4: Average Transaction price liquidity for the transaction will be good; the converse holds if

estimate with two parameters one follows the market. The reaction function (4) offers only

one scaling parameter and has a linear approximation for

small changes. Thus it may not offer enough flexibility to

account for distinct bid and ask liquidity. One simple modifica-

tion would be to replace (4) by

and is the indicator function. Figure 4 shows an

actual order book snapshot and a two parameter esti-

mate.

This modification, however, makes the model path-

Figure 5: dependent and we cannot solve it through the tree

structure any longer. Instead, a large-scale dynamical

programming algorithm, possibly with approximations,

would have to be employed (see Edirisinghe, Naik &

Uppal,1992).

PARAMETERIZATION AND

CALIBRATION OF THE MODEL

Krakovsky (1999), explicitly defines liquidity as the reciprocal

of i.e. the sensitivity of the stock price to the quantity

traded. However, in this form the parameter is not dimension-

less and depends on the absolute size of both the quantity and

nominal stock price. Abetter measure would be to treat the

Calculating the liquidity-modified values for put product as a dimensionless variable. In this

options with time to expiry of one year, 50 time steps, case . The liquidity parameter therefore becomes

strike of 50, annualized riskless rate of 5 per cent and observable at the time of the trade, since the market depth is

volatility of 20 per cent gives the results, which can be visible. Figure 5 shows for all the subsequent trades in one

seen in the Results Tables published on the Wilmott particular trading day.

website. To make liquidity more comparable across different

The case implies that there is no permanent slippage stocks and markets we would need to make the denom-

effect. The other market participants did not consider the trade inator dimensionless as well. This could be done by

to be based on fundamental information. In this case the dividing it by the total quantity traded across the time

model resembles the pure transaction cost models of Boyle & interval in question. That means, that one’s own trades

Vorst (1992), Bensaid, Lesne, Pagès & Scheinkman (1992), are treated as a fraction of the total market. However the

and Edirisinghe, Naik & Uppal (1993). In fact, we can deduce total trade size in general is not predictable.

the value of the manipulation effect of illiquid markets by

subtracting the result of a particular choice of from the result CONCLUSION

for . We believe that our model offers a flexible, simple but real-

The calculated prices represent the seller’s price, i.e. istic approach to parameterizing liquidity. It relies on inputs

how much a writer would require or a buyer would need that are either directly observable or possible to estimate.

to pay for. By multiplying the payoffs by we obtain the Moreover, the speed of calculation entirely depends on the

buyer’s price, i.e. how much the customer would obtain for choice of optimization algorithm employed. Also, this model

entering into this position. These two prices, which due to may offer the framework for a number of related applications

the nonlinearity of the model will not be the same, repre- that primarily depend on liquidity.

sent natural bid-ask spreads that are founded on the

degree of illiquidity of the market for the underlying. The PORTFOLIO TRADING

tables above show the bid-ask spreads for different Portfolio trading is the liquidation or rebalancing of a large

scenarios. portfolio of one or more stocks. In general, the portfolio is

assumed to be large enough to move a market substan-

DISTINCT BID AND ASK LIQUIDITY tially, so that it has to be broken up into smaller chunks.

Typically, the market depth on the bid and ask side (and thus Sometimes an agent guarantees a client the liquidation

liquidity) is not equal. If there exist large imbalances this usually price in advance, usually in terms of a spread around the

leads to increased volatility and to price movements. In that volume weighted average price over a period of time.

case i.e. buying when everybody is selling and vice versa, the Depending if it is necessary to return any outperformance

5

David Bakstein’s Let it Flow Wilmott July 2001

of the vwap to the client or not, the initial agreement repr FOOTNOTES

sents an option. The papers of Almgren & Chriss (1999) 1. This condition is for simplicity only. If there is an initial hold-

ing in the underlying, then the modifications if the model are

and Huberman & Stanzl (2000) deal with this problem by straightforward, but it has an effect on the valuation.

resorting to arithmetic Brownian motion, optimizing on 2. Strictly speaking, the filtration is given by the -alge-

objective function that trades off return against variance, bra of the given partition at every , i.e. all the unions and

complements of the elements of .

scaled by a risk-aversion parameter. The implementation 3. We do not count the holdings or constraints.

with our model would be straightforward.

REFERENCES

LIQUIDITY OPTIONS • Almgren & Chriss, Value under liquidation, Risk, Dec. 1999

• Bensaid, Lesne, Pagès & Scheinkman, Derivative Asset

Scholes (1999), defines liquidity options as the right or obli- Pricing with Transaction Costs, Mathematical Finance 2, 1992

gation to buy or sell a certain amount of an asset at the quoted • Black & Scholes, The Pricing of Options and Corporate

spot price, exercisable within a prespecified time window. Liabilities, Journal of Political Economy 2, 1973

• Boyle & Vorst, Option Replication in Discrete Time with

Under perfect liquidity, this amounts to a call or put option with Transaction Costs, The Journal of Finance 1, 1992

a strike price of zero. Hence it would theoretically amount to • Chordia, Roll & Subrahmanyam, Order Imbalance, Liquidity

the forward price of the asset. However, when liquidity is not and Market Returns, UCLA, Working Paper, 2000

• Cox, Ross & Rubinstein, Option Pricing: A Simplified

perfect this valuation does not hold any longer, since it may Approach, Journal of Financial Economics, Sept. 1979

not be the cheapest alternative to take a static hedge up-front. • Edirisinghe, Naik & Uppal, Optimal Replication of Options with

Transactions Costs and Trading Restrictions, March 1993

• Frey, The Pricing and Hedging of Options in Finitely Elastic

Markets, University of Bonn, Discussion Paper, 1996

E XOTIC OPTIONS IN ILLIQU I D • Frey & Stremme, Market Volatility and Feedback Effects

MARKETS from Dynamic Hedging, University of Bonn, Discussion

Paper, 1995

Taleb (1997), mentions (possibly illegal) practices of a • Huberman & Stanzl, Arbitrage-free Price-update and Price-

large trader front-running the client who holds positions Impact Functions, Yale, Working Paper, 2000

in the market. The author also mentions that clients • Huberman & Stanzl, Optimal Liquidity Trading, Yale, Working

Paper 2000,

require a liquidity rebate when entering into positions in • Jarrow, Market Manipulation, Bubbles, Corners, and Short

illiquid markets, especially when exposed to knock-out Squeezes, Journal of Financial and Quantitative Analysis,

barriers. Our model may be extended to exotic, possibly Sept. 1992,

• Jarrow, Derivative Security Markets, Market Manipulation

non-Markovian payoffs, so that the manipulation effect and Option Pricing Theory, Journal of Financial and Quantita -

can be extracted. tive Analysis, June 1994

• Krakovsky, Pricing liquidity into derivatives, Risk, Dec. 1999

STRIKE DETECTION • Lo & Wang, Implementing Option Pricing Models When Asset

Returns Are Predictable, The Journal of Finance 1, 1995

Finally, our model may prove useful for the inverse prob- • Longstaff, Option Pricing and the Martingale, Review of Financial

lem: given that certain large trades are observed, is it Studies, 4, 1995

• Scholes, Liquidity options,Risk, Nov. 1999

possible to deduce where the trader wants the asset • Schönbucher, The feedback effects of hedging in illiquid

price to be or what position (strike, barrier) is defended. markets, University of Oxford, MSc Thesis, 1993

Lo & Wang, 1995, show how options should be priced • Sircar & Papanicolaou, General Black-Scholes models

accounting for increased market volatility from hedging strate-

when asset returns are correlated. Another possibility gies, Applied Mathematical Finance 1, 1998

would be to perform a maximum likelihood analysis, after • Taleb, Dynamic Hedging, Wiley, 1997

having observed a sequence of large trades. • Contact: bakstein@maths.ox.ac.uk;

work supported by the EPSRC, Charterhouse, Socrates and

All these applications form part of current research and ESF;

development. Hopefully some interesting results can be The author wishes to thank: Sam Howison, Hyungsok Ahn,

expected in the future. Jeff Dewynne, Henrik Rasmussen and Paul Wilmott for help-

ful comments.

6

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