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DFG-Project: The Effects of Market Frictions on Option Prices

The Deutschen Forschungsgemeinschaft (DFG, German Research Foundation) supports the following project (link to project description)



Classic option-pricing theory assumes that assets are traded on frictionless markets. In reality, however, different market frictions prevail, for example, asset illiquidity and funding restrictions for certain groups of market participants. Such market frictions can be substantial, as was observed during the global financial crisis of 2008 and 2009, and can have an important impact on option prices. The goal of this project is to understand how market frictions affect option prices and option returns. A major challenge for such an investigation is that the direction of price effects depends on net end-user demand for options. If the demand is positive, i.e., end-users want to buy options, market frictions should lead to higher prices, whereas a negative demand should lead to lower prices. Unfortunately, data on end-user demand, in particular for options on individual stocks, is rarely available. Therefore, an essential idea of the project is to develop and empirically test hypotheses about the relation between market frictions and option prices which don't require any knowledge of end-user demand in a first step. This step exploits the idea that frictions should increase the variation of option prices around an appropriate reference value. If the hypotheses are supported by empirical tests for the US stock options market, we can draw conclusions about end-user demand from the difference between option prices and reference values in a second step.The project's main question about the connection between market frictions and option prices is relevant both from a scientific and socio-political perspective. In face of the controversial debate about derivatives markets a better understanding of the functioning of these markets is very important for policy recommendations concerning the design of corporate risk management strategies as well as the design and regulation of options markets. By looking at different market frictions (illiquidity, incompleteness of markets, funding restrictions) and investigating their relative importance for price formation in different market periods the project makes an important contribution in this respect.

Working papers and publications within this DFG-Project:

DFG-Project: The Macroeconomic Determinants of the Term Structure of Illiquidity Premia

The Deutschen Forschungsgemeinschaft (DFG, German Research Foundation) supports the following project (link to project description)



Illiquid bonds pay a premium to compensate bond investors for the lack of liquidity. Our results from the first part of the project, however, suggest that a clear connection between illiquidity premiums and typical liquidity measures like the bid-ask spread is only significant during economic crises. Therefore, we ask the natural follow-up question, why existing liquidity measures seem to work only well in stress periods. Building on this question, we analyze how the measurement of liquidity in general should be adapted to the economic conditions. From a conceptual point of view, at least two reasons point towards a measurement of liquidity that depends on the economic context. First, typical liquidity measures calculated from completed transactions provide only an incomplete picture. The reason is that transactions that have not been executed due to extreme illiquidity do not show up in the data. Second, for bond illiquidity premiums, expected transaction costs at the future trading date are the relevant costs and not today's transaction costs. Since transaction costs increase strongly in times of economic stress, it remains unclear whether current liquidity in calm periods is a good proxy for expected future transaction costs. In the proposed second part of the project, we first want to develop a forecasting model for expected transaction costs. For that, the remaining maturity of the bond as a natural ceiling on the holding horizon plays a central role, leading to a term structure of liquidity measurement. In the second step, we use the liquidity measures derived from the forecasting model to re-assess the impact of illiquidity on bond prices. The explanatory power of the newly developed liquidity measure in this exercise also serves as a criterion to evaluate and compare different measures. Since we are not aware of an approach to measure liquidity dependent on the economic environment in any security market, we plan to extend our analysis to the stock market in the last step. We expect that our results have practical influence in at least two ways. First, our forecast model provides expected trading costs for bonds, for which there are few or no data. From a practical perspective, information on trading costs is very important for these illiquid securities. Second, our new measures allow establishing a connection between the liquidity of a security and the associated price impact at an arbitrary point during the business cycle. Financial institutions could then apply, for example, scenario analyses, to predict the impact of a deterioration of liquidity in times of crisis, which would improve risk management.

Working papers and publications within this DFG-Project:

Interview lookKIT

Marliese Uhrig-Homburg und Philipp Schuster in an interview about the DFG-Project "The Macroeconomic Determinants of the Term Structure of Illiquidity Premia". The interview is available online here (p. 28).

DFG-Project: Modellierung und Quantifizierung von Kreditrisiken unter besonderer Berücksichtigung von Ausfallabhängigkeiten

The Deutschen Forschungsgemeinschaft (DFG, German Research Foundation) supported the following project until 2009 (link to project description)



The adequate consideration of default dependencies is one of the most crucial problems in credit risk management. Such dependencies can arise from common risk factors, learning from defaults or contagions. The aim of the project is the theoretical and empirical analysis of default dependencies. For this purpose we develop a theoretical framework that can in principle produce default dependencies in a realistic magnitude and that is furthermore consistently applicable on a large number of borrowers. Using the advantages of a top-down construction we first specify the economy-wide default intensity. Afterwards we apply the concept of random-thinning to break down the economy-wide default risk to subportfolio or single-name level. The evaluation of the models happens in two ways. Within a simulation study we analyze which dependencies can be achieved in our framework in general. We compare the derived default correlations and their consequences for the valuation of credit derivatives to the most important bottom-up approaches. An empirical verification of the model using market data of correlation sensitive credit derivatives should shed light on the question if this model can be a real-world solution.

Working papers and publications within this DFG-Project: