Liquidity Risk and Classical Option Pricing Theory

The purpose of this paper is to review the recent derivatives security research involving liquidity risk and to summarize its implications for practical risk management. The literature supports three general conclusions. The first is that the classical option price is "on average" true, even given liquidity risk. Second, it is well known that although the classical (theoretical) option hedge can not be applied as theory prescribes, its discrete approximations often provide reasonable approximations. These discrete approximations are also consistent with upward sloping supply curves. And, third, risk management measures like value-at-risk (VaR) are biased low due to the exclusion of liquidity risk. A simple adjustment for incorporating liquidity risk into standard risk measures is provided.