The Market Microstructure of Illiquid Option Markets and Interrelations with the Underlying Market Draft Version

Understanding and measuring determinants of bid-ask spreads is decisive to clarifying the efficiency of the microstructure of any exchange and general market liquidity. This paper examines the market microstructure of a low liquidity, market maker driven option market, the relations to the underlying securities’ market and the challenges of pricing liquidity. Comparing empirical results with prior research we find support for the “derivative hedge theory, in which option percentage spreads are inversely related to the option market maker's ability to hedge his positions and this in proportion to associated costs. We take the approach that option market makers’ costs represented by the bid-ask spread are determined from market activity and individual option characteristics. In a second step cross option market and underlying asset market characteristics are incorporated in the analysis.We model the bid-ask spread with order processing and delta hedging costs, inventory holding costs and competition. We find that the option bid-ask spread positively depends on delta hedging costs and the bid-ask spread of the underlying security. Adverse to prior research we observe that larger option trading volume significantly reduces realized option bid-ask spreads. JEL Codes: C33, G13, G14, G24